Annual Report (Form 10-K), fiscal year 1994

ITEM 1. BUSINESS
THE COMPANY
Southeastern Michigan Gas Enterprises, Inc. (the Company) was formed as a holding company in 1977 and has four direct subsidiaries. The Company provides professional and technical services to the consolidated group in the areas of finance, accounting, tax, risk management, legal, human resources, and information systems. The Company and its subsidiaries employ approximately 540 persons throughout the state of Michigan.
Southeastern Michigan Gas Company (Southeastern), Battle Creek Gas Company (Battle Creek) and Michigan Gas Company (Michigan Gas) (collectively, the utility subsidiaries) purchase, distribute and transport natural gas to 220,000 customers in twenty-three counties in the lower and upper peninsulas of Michigan. These operations generate approximately 90% of consolidated income. Set forth in the table below is sales and transportation information for the past three years:
Residential and commercial gas sales customers use natural gas primarily for space heating purposes. Consequently, weather has a significant impact on sales to these customers. For the same reason, the Company's operations are seasonal with most gas sales revenue being earned in the first and fourth quarters.
In the industrial markets, the utility subsidiaries principally provide natural gas transportation service. Many larger volume users purchase their own gas supply and rely on the utilities for transportation service. In
addition to transportation, the utilities also provide natural gas storage, backup supply and balancing services. Industrial sales and transportation revenues are primarily dependent upon the comparative cost of alternate fuels, economic conditions and government policies.
Other utility operations include the sale of natural gas-fired equipment, including heating units, home appliances and NGV equipment. In addition to sales, the utilities offer financing, installation, service and repair options.
Southeastern and Michigan Gas are subject to the jurisdiction of the MPSC as to various phases of their operations including rates, accounting, service standards and the issuance of securities. Battle Creek is subject to the jurisdiction of the MPSC as to various phases of its operations including accounting, service standards and issuance of securities, but not as to rates. Battle Creek's rates are subject to the jurisdiction of the City Commissioners of Battle Creek, Michigan.
SEMCO Energy Services, Inc. (SEMCO) is a diversified company with operations and investments in many segments of the natural gas industry. SEMCO's principal operating activity is natural gas marketing. SEMCO markets gas to approximately 150 customers located in several states. Its customers include industrial, commercial and municipal natural gas users, natural gas distribution companies and other marketers.
SEMCO purchases and markets natural gas to customers on a month-to-month basis and under long-term agreements. SEMCO also arranges for transportation of gas supplies to the customers' premises, offers storage capacity, contract administration and a variety of risk management services.
SEMCO's activities also include operations and interests in natural gas transmission and gathering systems and an underground gas storage system.
SEMCO, through its subsidiaries Southeastern Development Company and Southeastern Financial Services, Inc., also manages the leasing of motor vehicles and data processing equipment to companies in the consolidated group and oversees the real estate operations of the Company. SEMCO has no plans to expand its real estate operations.
Set forth below are SEMCO's gas marketing revenues, cost of gas marketed, volumes, average number of customers and earnings (loss) from equity investments for the past three years:
SEMCO's gas marketing margins and volumes are sensitive to the comparative costs of alternate fuels, seasonal patterns and competition within the gas marketing industry. With the implementation of FERC Order 636, the gas marketing industry is facing increased competition, but is also pursuing increased opportunities. See "Management's Discussion and Analysis" for further discussion relating to Order 636.
Gas Supply. The service territories of the utility subsidiaries are served by four major interstate pipelines: Panhandle Eastern Pipe Line Company, Northern Natural Gas Company, Great Lakes Gas Transmission Company and ANR Pipeline Company.
During 1994, the utility subsidiaries purchased 70% of their natural gas volumes from firm suppliers and 28% from the spot market. Nearly 40% of the firm supply volumes were purchased under fixed-price contracts, while the other 60% were purchased under contracts indexed to the spot market. Less than 2% of 1994 gas purchases were from interstate pipelines and intrastate suppliers.
Natural gas purchases are transported to the utility subsidiaries' systems under various firm and interruptible transportation arrangements with interstate and intrastate transmission companies.
The utility subsidiaries utilize on-system and leased storage capacity of approximately 40% of annual gas sales volumes to reduce their reliance on the interstate pipelines for peak day needs and allow for the purchase of natural gas at lower prices.
The utility subsidiaries own underground storage facilities with a working capacity of 5.0 Bcf. In addition, they lease 6.5 Bcf of storage from Eaton Rapids Gas Storage System and 4.0 Bcf from non-affiliates. SEMCO Gas Storage Company (an affiliated company) is a 50% owner of Eaton Rapids Gas Storage System.
SEMCO obtains its gas supply from various production sources, primarily located in Louisiana, Oklahoma and Michigan. SEMCO generally contracts for gas supply on a monthly basis, however, it does enter into some long-term gas purchasing arrangements. See Note 6 of "Notes to the Consolidated Financial Statements" for a description of SEMCO's hedging activities as they relate to SEMCO's gas supply strategy.
New Business. Since 1987 the utility subsidiaries have added approximately 5,000 gas sales customers per year. Customer additions have been primarily residential and commercial.
Clean air legislation and resultant pressures on industry and electric utilities to reduce emissions from their plants continue to support interest in natural gas as an industrial fuel. The use of natural gas as a primary vehicle fuel is also receiving serious attention for the same environmental reasons.
Rates and Regulation. Management continually reviews the adequacy of the utility subsidiaries' rates. It is management's intention to file requests for rate increases whenever it is deemed necessary and appropriate. There have been no general rate filings by Southeastern since 1983 or Michigan Gas since 1990. Battle Creek last placed new rates into effect in 1991.
In 1992, the MPSC issued a generic order addressing the accounting for the cost of postretirement benefits other than pensions. Pursuant to this order, the utility subsidiaries plan to file rate cases before 1996 in order to recover certain expenses related to this change in accounting treatment. Any relief granted will be based on all elements of cost of service. See Note 7 of "Notes to the Consolidated Financial Statements" for further discussion.
Competition. Natural gas competes with other forms of energy available to customers, primarily on the basis of rates. These competitive forms of energy include electricity, coal, propane and fuel oils. Changes in the availability or price of natural gas or other forms of energy, as well as business conditions, conservation, legislation, regulations, capability to convert to alternate fuels and other factors may affect the demand for natural gas in areas served by the Company's subsidiaries.
The Company's subsidiaries sell natural gas to and transport natural gas for several large customers who have the ability to use alternate fuels.
SEMCO's natural gas marketing operations compete with other marketing firms on the basis of price, the ability to arrange suitable transportation to the customer's premises and the ability to provide related services such as pipeline nominations and balancing.
FERC Order 636 has increased competition in the natural gas industry as pipelines unbundled their services and instead offer separate service for gas transportation, storage and gathering. See "Management's Discussion and Analysis" for a further discussion of Order 636.
ITEM 2.



ITEM 2. PROPERTIES
The properties of the Company consist of the Common Stock of Southeastern, Michigan Gas, Battle Creek, SEMCO, and leasehold improvements and office equipment.
SOUTHEASTERN MICHIGAN GAS COMPANY
Southeastern owns gas supply systems which, on December 31, 1994, included approximately 112 miles of transmission pipelines and 1,798 miles of distribution pipelines. The pipelines are located in southeastern Michigan (centered in and around the City of Port Huron) and south-central Michigan (centered in and around the City of Albion).
Southeastern's distribution system and service lines are, for the most part, located on or under public streets, alleys, highways, and other public places, or on private property not owned by Southeastern with permission or consent, except to an inconsequential extent, of the individual owners. The distribution system and service lines located on or under public streets, alleys, highways, and other public places were all installed under valid rights and consents granted by appropriate local authorities.
Southeastern's underground storage system consists of six salt caverns and a depleted gas field, located in St. Clair County, Michigan, together with measuring, compressor and transmission facilities. The aggregate working capacity of the system is approximately 3.4 Bcf, with a capacity to deliver 85 MMcf on a peak day.
Southeastern also owns meters and service lines, gas regulating and metering stations, garages, warehouses and other buildings necessary and useful in conducting its business. Southeastern leases its computer and transportation equipment.
BATTLE CREEK GAS COMPANY
Battle Creek owns gas supply systems which, on December 31, 1994, included approximately 27 miles of transmission pipelines and 624 miles of distribution pipelines. The pipelines are located in southwestern Michigan (centered in and around the City of Battle Creek, Michigan).
Battle Creek's distribution system and service lines are, for the most part, located on or under public streets, alleys, highways, and other public places, or on private property not owned by Battle Creek with permission or consent, except to an inconsequential extent, of the individual owners. The distribution system and service lines located on or under public streets, alleys, highways, and other public places were all installed under valid rights and consents granted by appropriate local authorities.
Battle Creek owns and operates underground gas storage facilities in a depleted salt cavern and two depleted gas fields. The aggregate working capacity of the storage system is approximately 1.6 Bcf.
Battle Creek also owns meters and service lines, gas regulating and metering stations, garages, warehouses and other buildings necessary and useful in conducting its business. Battle Creek leases its computer and transportation equipment.
MICHIGAN GAS COMPANY
Michigan Gas owns gas supply systems located in the southwest portion of Michigan's lower peninsula and the central and western areas of Michigan's upper peninsula. The systems include 2,019 miles of distribution pipeline, meters, service lines, gas regulating and metering stations, garages, warehouses, and other buildings necessary and useful in conducting its business. Michigan Gas leases its computer equipment, transportation equipment, and certain buildings.
Michigan Gas's distribution system and service lines are for the most part, located on or under public streets, alleys, highways, and other public places, or on private property not owned by Michigan Gas with permission or consent, except to an inconsequential extent, of individual owners. The distribution system and service lines located on or under public streets, alleys, highways, and other public places were all installed under valid rights and consents granted by appropriate local authorities.
SEMCO ENERGY SERVICES, INC.
The principal properties of SEMCO and its affiliates include interests and operations in natural gas transmission and gathering systems and an underground gas storage system.
Set forth in the following table are the equity investments of SEMCO and its affiliates, the total non-current asset balance of each entity, and SEMCO's ownership percentage and equity investment at December 31, 1994:
SEMCO Arkansas Pipeline Company (a wholly-owned subsidiary of SEMCO) is a 32% general partner in the NOARK Pipeline System. The partnership operates a 302-mile pipeline crossing northern Arkansas which completed its first year of service in 1993. The pipeline provides area producers access to interstate and intrastate pipelines. See Note 8 of the "Notes to the Consolidated Financial Statements" for a discussion of commitments made relating to this project.
SEMCO Gas Storage Company (a wholly-owned subsidiary of SEMCO) owns a 50% equity interest in the Eaton Rapids Gas Storage System. This system, located near Eaton Rapids, Michigan, became operational in March 1990 and consists of approximately 12.8 Bcf of underground storage capacity. Of the total, 12 Bcf is leased under long-term contracts and 7.3 Bcf is leased by the Company's subsidiaries.
SEMCO Pipeline Company (SEMCO Pipeline) (a wholly-owned subsidiary of SEMCO) is an 11% owner of Nimrod Natural Gas Corporation (Nimrod) of Tulsa, Oklahoma. Nimrod engages in the installation or purchase and operation of natural gas gathering systems. These systems purchase, collect and re-sell wellhead natural gas delivering it to major transportation pipelines for redelivery to customers.
SEMCO Pipeline also owns 50% of the Michigan Intrastate Pipeline System and the Michigan Intrastate Lateral System partnerships. The sole purpose of these partnerships is to hold a 10% ownership of the Saginaw Bay Pipeline Project, a 126-mile pipeline from Michigan's Saginaw Bay area to processing plants in Kalkaska, Michigan.
The following table sets forth the operations wholly or partially owned by SEMCO and its affiliates, the total net property of the project, and SEMCO's ownership percentage and net property at December 31, 1994:
SEMCO Pipeline is a 33% owner in the Litchfield Lateral, a 31-mile pipeline located in southwest Michigan. The line, which is leased entirely to ANR Pipeline Company, links the Eaton Rapids Gas Storage System with interstate pipeline supplies. The Litchfield Lateral began operations in February 1993.
In 1991, SEMCO Pipeline constructed an 18-mile pipeline to serve Detroit Edison's Greenwood power plant located in Michigan's thumb area. SEMCO Pipeline and Detroit Edison have entered into an agreement whereby Detroit Edison has contracted for the entire capacity of the line of 240 MMcf per day.
SEMCO Pipeline is a 40% owner of the Iosco County Pipeline and Reno Gas Processing Plant (Iosco-Reno System), which was placed in service in March 1992. The Iosco-Reno System gathers and processes wet gas in the Au Gres and Santiago fields located in mid-Michigan for delivery to the processing plant and ultimate delivery to the gas markets.
SEMCO Pipeline completed the 7.1-mile Eaton Rapids Pipeline in 1990, providing direct delivery of gas from the Eaton Rapids Gas Storage System to Battle Creek and Southeastern's Albion division.
Other properties of SEMCO consist of vehicles and data processing equipment primarily leased to affiliates, real property and related improvements held for resale, office properties leased to affiliates and third parties, and its equity investment in the Dunn/SECO cogeneration venture. These other properties total $4.9 million or 2.1% of consolidated utility plant and other property, net.
ITEM 3.

ITEM 3. LEGAL PROCEEDINGS
Refer to Note 8 of "Notes to the Consolidated Financial Statements" for information regarding a lawsuit involving several parties including the NOARK Pipeline System and SEMCO Arkansas Pipeline Company.
ITEM 4.

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

ITEM 5. MARKET PRICE OF AND DIVIDENDS ON THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
COMMON STOCK DATA
The common stock of the Company is traded on The Nasdaq Stock Market under the symbol "SMGS." The table below shows high and low closing bid prices of the Company's common stock in the over-the-counter market as reported by the Detroit Free Press and quoted on NASDAQ/NMS, adjusted to reflect the 5% stock dividends in May 1994 and 1993. These quotations reflect dealer prices, without brokerage commission, and may not necessarily represent actual transactions.
See the cover page for a recent stock price and the number of shares outstanding.
See "Selected Financial Data" below for the number of shareholders at year end for the past five years.
DIVIDENDS
See Notes 4 and 10 of "Notes to the Consolidated Financial Statements" and "Selected Financial Data."
ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA
ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
RESULTS OF OPERATIONS
Net Income Net income available for common stock before extraordinary item was $11.3 million ($1.02 per share) for the year ended December 31, 1994. This represented an increase of $1.6 million over the $9.7 million ($.97 per share) net income available for common stock before extraordinary item for the year ended December 31, 1993. The Company recorded extraordinary charges for 1994 and 1993 of $1.3 million ($.12 per share) and $177,000 ($.01 per share), respectively, for the early extinguishment of debt. The increase in net income before extraordinary items primarily reflects improved results from the Company's natural gas marketing operations, the interest savings generated by the Company's refinancing of certain higher rate debt and lower depletion charges in 1994 related to the Company's remaining oil and gas operations. These earnings were partially offset by an increase in the loss from the investment in the NOARK Pipeline System and a decrease in total gross margin generated by the Company's natural gas distribution operations. The change in per share amounts also reflects the impact of the sale of 747,500 new common shares in January 1994 and the sale of 307,000 shares through the DRIP. For 1993, net income available for common before extraordinary item increased $529,000 from $9.2 million ($.95 per share) in 1992 to $9.7 million ($.97 per share). The improvement in net income before extraordinary item was primarily due to increased earnings from the Company's natural gas distribution operations. Colder weather and customer additions resulted in a 4.4% increase in natural gas volumes sold. Earnings from natural gas marketing, gas transmission and gas gathering operations also increased in 1993 compared to 1992. Natural gas volumes marketed increased 6.3% over 1992 levels along with higher per unit marketing margins. In addition, gas transmission and gathering projects, other than NOARK, placed in service during recent years realized throughput closer to capacity. These earnings offset a loss in 1993 from the Company's investment in the NOARK Pipeline System, which began operations in September 1992, and higher charges related to the Company's remaining oil and gas exploration and production operations.
Operating Revenues and Gross Margin Natural Gas Distribution. The Company's natural gas distribution business involves the operations of Southeastern, Battle Creek and Michigan Gas. These companies generate revenue mainly through the sale and transportation of natural gas. The following table compares sales and transportation information for the last three years:
Natural gas sales volumes and gross margin from gas sales decreased 40 MMcf and $302,000, respectively, for 1994 compared to 1993. The addition of an average of 5,560 new gas sales customers in 1994, a 2.6% increase, helped reduce the impact of warmer temperatures on natural gas usage by the weather-sensitive residential and commercial customers. Temperatures during 1994 were 2.7% warmer than 1993 and 2.4% colder than normal. For 1993, compared to 1992, gas sales volumes and margin increased 1,655 MMcf and $3.3 million, respectively. Temperatures during 1993 were 2.5% colder than 1992 and 5% colder than normal. In addition, the average number of gas sales customers increased by 5,683 in 1993 compared to 1992, an increase of 2.8%. Transportation volumes increased 2,220 MMcf in 1994 from 1993 while transportation revenues increased slightly. The increase in volumes relative to revenues reflects the pressure of competition on transportation margins and the impact of additional volumes transported by certain lower margin customers, including coal-displacement customers, in 1994 compared to 1993. Coal-displacement volumes are sensitive to natural gas prices relative to coal and are priced at lower margins. For 1993 compared to 1992, transportation volumes decreased 3,074 MMcf while revenues increased slightly. Due to the relative prices of coal and natural gas during 1993, the Company did not benefit from any coal-displacement volumes. In 1992, however, the Company transported significant coal-displacement transportation volumes. Natural Gas Marketing. Total marketing margin increased to $4.3 million in 1994, or 23%, from $3.5 million in 1993. Volumes marketed increased to 78,082 MMcf in 1994, or 148%, from 31,501 MMcf in 1993. The increase in gas marketing volumes in 1994 compared to 1993 is primarily attributable to the 1993 implementation of the FERC Order 636 (Order 636). With interstate pipelines no longer able to sell "bundled" natural gas sales services with gathering, transportation and storage services, the demand for natural gas marketing and related services has increased. SEMCO has responded to this increased demand with new gas marketing services and more aggressive marketing efforts. The decrease in per unit marketing margins in 1994 compared to 1993 is due to the expiration of several high-margin contracts which were outstanding in 1993 and increased competition fostered by Order 636.
For 1993 compared to 1992, total marketing margin increased $1.3 million from $2.2 million while volumes marketed increased 1,864 MMcf from 29,637 MMcf. Generally, the price of alternate fuels, seasonal patterns and competition in the industry contribute to the fluctuation in margins per unit of gas marketed and the volumes marketed. In addition, the increased volumes reflected SEMCO's emphasis on an expanded level of marketing-related services coincident with Order 636 and an increase in marketing staff. While marketing volumes and total margin have substantially increased in recent years, SEMCO's future marketing volumes and margins are subject to significant competitive factors. In addition to fluctuations caused by the price of alternate fuels and seasonal patterns, competition within the industry is likely to increase as companies continue to adapt to the post-Order 636 environment. Other Operating Revenues. Other operating revenues consist principally of the revenues generated by natural gas transmission and gathering activities, miscellaneous utility operations and a natural gas cogeneration project. Also included in other operating revenues are revenues generated by oil and gas exploration and production, equipment leasing and real estate development. Other operating revenues totalled $6.2 million, $6.4 million and $6.1 million in 1994, 1993 and 1992, respectively. The change in other operating revenues reflects increases resulting from SEMCO's interest in the operations of various natural gas transmission and gathering projects placed in service in recent years and decreases resulting from the Company's declining involvement in equipment leasing, real estate development and oil and gas activities since 1991.
Operating Expenses and Income Deductions Operations expense increased $812,000, or 2.7%, in 1994 compared to 1993. Of the increase, $437,000 resulted from additional retiree medical expenses in 1994. Pursuant to an MPSC Order, Southeastern and Michigan Gas were required to use savings generated by property tax reductions in the State of Michigan to offset an equal amount of the retiree medical regulatory asset. As a result, Southeastern and Michigan Gas expensed $437,000 of the retiree medical regulatory asset in 1994. The remaining increase reflects expenses associated with payroll and employee benefits, principally pension and medical. For 1993 compared to 1992, operations expense increased $817,000, or 2.8%. This increase resulted primarily from operating costs for distribution and underground gas storage systems and expenses associated with additional customers. Maintenance expense increased $250,000, or 5.8%, in 1994 compared to 1993. This increase is primarily attributable to repairs necessitated by extremely cold temperatures in the first quarter of 1994. Depreciation expense decreased by $919,000, or 7.3%, in 1994 compared to 1993. The overall decrease results from lower depletion costs in 1994 than 1993 and the reduction in depreciation expense caused by the decline in non-affiliate equipment leasing activities. Partially offsetting the decrease in depreciation resulting from these items was an increase in depreciation expense associated with the growth in utility plant.
Depreciation expense increased $124,000, or 1.0%, in 1993 compared to 1992. The increase over 1992 reflects depreciation expense associated with growth in utility plant and other property and depletion associated with the Company's remaining oil and gas properties, partially offset by reductions in depreciation expense resulting from the reduction of property leased to non-affiliates. Income taxes decreased $394,000 in 1994 compared to 1993 and increased $1.7 million in 1993 compared to 1992. These amounts reflect the year-to-year increase in pretax income and a higher annual expense in 1993 resulting from the cumulative effect of the increase in the statutory tax rate from 34% to 35% and adjustments to prior years' taxes provided. Taxes other than income taxes were $8.2 million, $8.4 million and $7.7 million for 1994, 1993 and 1992, respectively. Taxes other than income taxes consist primarily of property taxes. The year-to-year change in property taxes reflects growth in the Company's gas distribution, transmission and gathering plant, offset by property tax reductions in the State of Michigan in 1994. The savings generated by the 1994 property tax reductions were used to offset an equal amount of retiree medical costs pursuant to an MPSC Order affecting Southeastern and Michigan Gas, as discussed above. Interest on long-term debt decreased $821,000 in 1994 compared to 1993. This decrease results from the Company's refinancing activities during 1994 as discussed below. Other interest expense, consisting primarily of interest on short-term borrowings, increased slightly in 1994 over 1993 and increased $365,000, or 26%, in 1993 compared to 1992. The average balance in short-term borrowings was $31.4 million in 1994, $42.3 million in 1993 and $22.3 million in 1992 at weighted average interest rates of 5.2%, 4.1% and 4.5%, respectively. The decrease in average borrowings in 1994 compared to 1993 results from the refinancing of the permanent portion of short-term debt with common equity in January 1994 and a temporary excess cash position due to the timing of refinancing certain long-term debt issues, offset by an increase in working capital requirements associated with the growth in natural gas marketing. The increased level of borrowings from 1992 to 1993 substantially results from the accumulation of permanent capital needs generated by capital expenditure programs.
Other Income (Loss), Net Other income (loss), net, consists primarily of income from SEMCO's equity investments but also includes miscellaneous nonoperating income and expense items, net of tax. Other income (loss), net, was ($42,000), $41,000 and $562,000 in 1994, 1993, and 1992, respectively. Specific items reflected in the year-to-year changes are losses from the investment in the NOARK Pipeline System of $1.2 million, $834,000 and $233,000 in 1994, 1993 and 1992, respectively. Partially offsetting the impact of this item on other income, net, were year-to-year improvements in the overall earnings from the Company's investment in storage and gathering activities. NOARK was placed in service in September 1992 and has an operating capacity of 141,000 Mcf a day. Through a subsidiary, the Company holds a 32% general partnership interest in the $103 million pipeline.
NOARK has been operating below capacity and generating losses since it was placed in service. The pipeline experienced significant cost overruns during construction which resulted in higher financing costs than expected. Competition from two interstate pipelines in the Arkansas region has required NOARK to discount its transportation charges to attract volumes to the pipeline. Additionally, in December 1993, a major shipper of firm volumes on the NOARK Pipeline System, Vesta Energy Corporation (Vesta), initiated legal action against several defendants, including NOARK. Effective January 1, 1994, Vesta discontinued shipments of gas pursuant to its contract and ceased payment of the firm demand fee. See Note 8 of Notes to the Consolidated Financial Statements for further discussion of the recent legal actions involving NOARK and the Company's guarantees related to the pipeline's financing. During 1994, NOARK had firm contracts averaging 51,000 Mcf a day at a demand fee equal to approximately 19.3 cents per Mcf. From January through May 1994, an affiliate of Southwestern Energy Pipeline Company, a NOARK general partner, which was providing 25,000 Mcf per day of the gas transported by Vesta over the NOARK system, shipped those volumes over the system at the full firm rates. Actual gas volumes transported by the pipeline during 1994 averaged nearly 82,000 Mcf a day, or 58% of capacity, at both firm and interruptible rates. During 1993, NOARK had firm contracts averaging 73,000 Mcf a day at the 19.3 cent demand fee. Actual gas volumes transported by the pipeline during 1993 averaged nearly 79,000 Mcf a day, or 56% of capacity, at both firm and interruptible rates.
Liquidity And Capital Resources Cash Flows. The Company's net cash provided from operating activities totalled $28.3 million in 1994, $12.1 million in 1993 and $3.2 million in 1992. The change in operating cash flows is significantly influenced by changes in the level and cost of gas in underground storage, accounts receivable and accrued revenue, gas cost recoveries and accounts payable. The changes in these accounts are largely the result of the timing of receipts and payments. The Company uses significant amounts of short-term borrowings to finance natural gas purchases for storage during the non-heating season to sell during the heating season. The Company owns and leases natural gas storage facilities with available capacity approximating 40% of annual gas sales. Generally gas is stored during the months of April through October and withdrawn for sale from November through March. The carrying amount of natural gas stored underground peaked at $45.9 million, $45.7 million and $42.1 million in October 1994, 1993 and 1992, respectively. In 1994, net cash used by financing activities was $5.6 million while in 1993 and 1992, net cash from financing activities totalled $12.0 million and $26.3 million, respectively. During 1994, the Company received $20.4 million through the January 1994 sale of 747,500 shares of common stock and the additional sales of common stock through the DRIP. The Company also received $80.0 million through the June 1994 issuance of $55.0 million, 8.00% Senior Notes and $25.0 million, 8.32% Senior Notes. The proceeds of these financings were used principally to redeem the following long-term debt instruments (in thousands of dollars):
Expensing of the portion of the call premiums and unamortized debt expense associated with the Company's non-regulated operations resulted in a $1.3 million ($.12 per share) extraordinary charge to income in 1994 and $177,000 ($.01 per share) in 1993. In connection with the redemption of debentures, Southeastern and Michigan Gas received approval from the MPSC in June 1994 to redeem corresponding long-term debt owed to the Company and to redeem Southeastern's first mortgage bonds by issuing $23.0 million and $31.0 million, respectively, of long-term debt securities to the Company. During 1994, funds were also used for the payment of dividends and for the reduction of short-term borrowings. During 1993, $20.0 million in funds was provided through a term loan, due May 31, 1997, and $5.9 million in funds was provided from the DRIP. During 1993, funds were used for the payment of dividends and to repay certain portions of long-term and short-term debt. In addition to funds provided from the DRIP and short-term lines of credit in 1992, the Company issued $25.0 million of 8-5/8% debentures due in 2017. Funds in 1992 were used for the payment of dividends and to redeem $14.9 million in 11-1/2% debentures originally due 2000 at 105% of face value. This redemption resulted in an extraordinary charge to income of $901,000 ($.10 per share) in 1992. The following table identifies capital expenditures for the last three years:
Capital expenditures by the Company's natural gas distribution companies amounted to $20.4 million in 1994. In addition to normal plant repair and replacement expenditures of $9.3 million, $11.1 million was spent for new customer additions. Of the $19.2 million spent by the distribution companies in 1993, $11.8 million was for new customer additions. The remainder was primarily for normal repair and replacement projects. In 1992, the distribution companies spent $14.3 million for new customer additions and the remainder primarily on normal repair and replacement of distribution properties. Capital expenditures for gas transmission, gathering and storage in 1994 principally reflect a contribution of $640,000 to NOARK for the final payment of construction retainage.
For 1993, capital expenditures for operations other than natural gas distribution were principally to complete the Litchfield Lateral pipeline. Of the transmission, gathering and storage capital expenditures in 1992, $5.1 million was spent on SEMCO's investment in the NOARK Pipeline System. Another $2.6 million was spent toward completion of the Litchfield Lateral project and $1.1 million toward the Iosco/Reno gas gathering and processing facility.
Future Capital Expenditures and Liquidity 1995 Capital Expenditures. For 1995, the Company plans to spend $24.8 million on capital additions. Of this amount, $19.9 million is planned for natural gas distribution operations, with $13.8 million targeted for new customer additions. Future Financing. Funds needed for the Company's 1995 capital expenditure program and dividend payments will be provided primarily through internally generated funds and utilization of short-term lines of credit. At year end 1994, the Company had short-term credit facilities totalling $89.9 million. Dividends reinvested by shareholders in the DRIP have reduced the level of funds required for dividend payments. In 1994, of the total dividends on common shares of $8.7 million, $3.2 million were reinvested. This portion of dividends, along with optional cash payments of $2.6 million, resulted in 306,908 new shares issued to existing shareholders in 1994. As a result, the DRIP has been a major factor in strengthening the Company's equity position. In addition, the Company further strengthened its equity position with the issuance of 747,500 shares of common stock in January 1994. At this time, the Company does not expect to require additional common equity funding during the next few years. As a result, the Company amended its DRIP in January 1995 to allow for the purchase of common shares on the open market in addition to allowing the use of newly issued shares to meet plan requirements. Except to the extent that purchase of shares on the open market becomes difficult, it is expected that newly issued shares will not be sold under the plan. The optional cash payment feature was also amended to reduce the maximum allowed from $100,000 a year to $5,000 a month. During 1995, the Company expects to make contributions to the NOARK Pipeline System in connection with its guarantees of the pipeline's debt. See Note 8 of Notes to the Consolidated Financial Statements for a discussion of the Company's guarantees related to the NOARK Pipeline System's financing and legal actions involving NOARK. Commodity Hedging. The Company's natural gas marketing subsidiary, SEMCO, has entered into various long-term sales commitments which may extend up to 24 months into the future. SEMCO maintains a hedging program with the objective of preserving the anticipated margin on these sales commitments. The hedges are designed to ensure that the impact of natural gas price fluctuations on the fair value of long-term sales commitments will be offset by the impact of such price fluctuations on the fair value of the hedging instrument. The most frequently used hedging instruments are natural gas futures and options although SEMCO may also enter into natural gas swap agreements, contract to purchase natural gas from producers for future delivery or inject gas into storage for later withdrawal.
Critical to the success of the hedging program is the performance by both the other party to the hedge and the marketing customer buying gas under the long-term sales commitment. SEMCO performs extensive credit reviews on new and existing marketing customers and only enters into hedging transactions with reputable dealers, primarily on the NYMEX, or directly with reliable suppliers. At December 31, 1994 and 1993, SEMCO had recorded net deferred losses from its hedging program of approximately $4.6 million and $2.4 million, respectively. At the same time, SEMCO had similar amounts of unrecorded gains pursuant to the underlying long-term sales commitments. See Note 6 of Notes to the Consolidated Financial Statements for further information regarding the types, underlying notional volumes, and fair values of SEMCO's hedges at December 31, 1994 and December 31, 1993.
Other Areas Adoption of New Accounting Standards. In the first quarter of 1993, the Company adopted two new standards issued by the FASB. SFAS 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" (SFAS 106) requires the accrual method of accounting for postretirement benefits. SFAS 109, "Accounting for Income Taxes" (SFAS 109) requires measurement and restatement of deferred tax assets and liabilities based upon the estimated future tax effects of temporary differences and carryforwards. Although the adoption of these standards did not have a material impact on the Company's results of operations, adoption of SFAS 106 by the utility subsidiaries has significant regulatory ratemaking implications. Pursuant to a generic order issued by the MPSC, the Company is recording a liability and a corresponding regulatory asset for the utilities' portion of SFAS 106 costs. The generic order provides for recovery of this regulatory asset provided a utility files a general rate case prior to 1996 and demonstrates the need for a rate increase to compensate for this additional cost. Every aspect of the business of a utility is open to scrutiny when its rates are redetermined. The outcome of future rate cases cannot be predicted. See Note 7 and Note 3 of the Notes to the Consolidated Financial Statements for further discussion of SFAS 106 and SFAS 109.
Impact of Inflation The cost of gas sold by the three distribution companies is recovered from natural gas distribution customers on a current basis. Although inflation has steadied in recent years, increases in other utility operating costs are recovered through the regulatory process of filing a rate case, and therefore may adversely affect the results of operations in inflationary periods due to the time lag involved in this process. The Company attempts to minimize the impact of inflation by controlling costs, increasing productivity and filing rate cases on a timely basis. It is likely the utilities will be filing rate cases before January 1996 in conjunction with the adoption of SFAS 106. See Note 7 of the Notes to the Consolidated Financial Statements.
Industry Trends Competition. The market prices of alternate sources of energy such as coal and #6 fuel oil compete directly with the price the utilities charge for industrial sales and transportation of gas. The prices of alternate fuels similarly affect the volumes and margins of the natural gas marketing operations of the Company. In addition, continued deregulation of the natural gas industry has further increased the sources of competition. See "Federal Regulation" discussion below. To lessen the impact of prices on fuel choice by industrial customers, the Company offers additional services, such as gas storage and balancing. However, the competition among fuels is expected to continue to affect volumes sold, transported and marketed and the associated margins. Federal Regulation. Interstate pipelines were required to comply with FERC Order 636 by the 1993-1994 heating season. Order 636, intended to increase competition within the gas industry, requires pipelines to unbundle their services and instead offer separate service for gas transportation, storage and gathering. Competition. As a result of this restructuring of the interstate pipeline service, natural gas distribution companies have the ability to select and pay for only those pipeline services they require. In addition, Order 636 allows customers on natural gas distribution systems to purchase the same level of unbundled service directly from the interstate pipelines. Under such circumstances, natural gas distribution companies generally provide transportation services to those customers. It is expected that the availability of unbundled pipeline services to customers will result in continued pressure on gas distribution companies to offer similar unbundled services in order to compete with the pipelines. This competition has resulted in pressure to reduce natural gas transportation margins. Currently, the utility subsidiaries are providing transportation services principally to large industrial customers. In addition to pressure on the transportation margins of the utility subsidiaries, Order 636 is impacting the natural gas marketing operations of SEMCO. Access to unbundled pipeline services is expected to attract new competitors to the marketing industry and present opportunities for marketers to offer expanded services to their customers. Gas Supply. Order 636 has the effect of shifting the risk of securing reliable gas supply and managing pipeline capacity from the interstate pipelines to local gas distribution companies. As a result, the utility subsidiaries face more complex gas supply procurement issues. The Company's utility subsidiaries are served by four interstate pipelines: Panhandle Eastern Pipe Line Company, ANR Pipeline Company, Great Lakes Gas Transmission Company and Northern Natural Gas Company. These pipelines received authority from the FERC to substantially implement their restructuring plans effective November 1, 1993. In conjunction with these plans, the FERC has given interstate pipelines authority to directly bill customers for certain transition costs resulting from the restructuring. As former purchasers of bundled interstate pipeline service, the utility subsidiaries are responsible for some of these transition costs. To date, the utility subsidiaries have been billed approximately $3.2 million in Order 636 transition costs. At this time, no further direct-billed transition costs are anticipated. As with previously FERC-mandated billings, Order 636 transition costs are recoverable from ratepayers through gas cost recovery mechanisms.
ITEM 8.


ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The accompanying notes to the consolidated financial statements are an integral part of these statements.
The accompanying notes to the consolidated financial statements are an integral part of these statements.
The accompanying notes to the consolidated financial statements are an integral part of these statements.
The accompanying notes to the consolidated financial statements are an integral part of these statements.
The accompanying notes to the consolidated financial statements are an integral part of these statements.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
1. SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation. The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries, Southeastern, Battle Creek, Michigan Gas and SEMCO. Investments in unconsolidated companies at least 20% owned, but not greater than 50% owned, are reported using the equity method of accounting. All significant intercompany transactions have been eliminated in consolidation. Certain previously reported amounts have been reclassified to conform with 1994 presentations. These reclassifications had no effect on net income. Rate Regulation. The Company accounts for the effects of regulation under SFAS 71, "Accounting for the Effects of Certain Types of Regulation." As a result, the actions of regulators affect when revenues, expenses, assets and liabilities are recognized. The rates of the utility subsidiaries, Southeastern, Battle Creek and Michigan Gas, are subject in certain respects to the requirements of state and local regulatory bodies. The MPSC authorizes the rates charged to customers by Southeastern and Michigan Gas. Battle Creek's rates are subject to the jurisdiction of the City Commission of Battle Creek, Michigan. Utility Plant, Other Property and Depreciation. Utility plant in service is recorded at cost. The utility subsidiaries provide for depreciation on a straight-line basis over the estimated useful lives of the related property. Included in other property are the nonutility fixed assets of the Company and its subsidiaries, reduced by the related accumulated depreciation. Generally, these assets are recorded at cost and depreciated on a straight-line basis over their estimated useful lives. The ratio of depreciation to the average balance of property approximated 4.1%, 4.3% and 4.6% for the years 1994, 1993 and 1992, respectively. Certain investments in unconsolidated companies recorded using the equity method are also reported as other property. See Note 9 for further discussion. Receivables, Gas Sales, Transportation and Marketing Revenues. Customer receivables, gas sales and transportation revenues arise from the operations of the utility subsidiaries. These subsidiaries deliver natural gas to a broadly diversified base of residential, commercial and industrial customers located within the state of Michigan. Marketing revenues and receivables arise from SEMCO's marketing operations. SEMCO markets natural gas to industrial customers, gas distribution utilities, and other gas marketers located in several states. Revenue Recognition. Southeastern, Michigan Gas and Battle Creek bill monthly on a cycle basis and follow the industry practice of recognizing accrued revenue for gas services rendered to their customers but not billed at month end. SEMCO recognizes marketing revenues, and any related hedging gains or losses, in the same period natural gas is delivered to customers. See Note 6 for further discussion about SEMCO's hedging activities. Gas in Underground Storage. Gas in underground storage for Southeastern and Michigan Gas is reported at average cost. Battle Creek's gas inventory is stated at last-in, first-out cost. At December 31, 1994 and 1993, the balance in this account approximates the replacement value of the gas in storage. SEMCO reports gas in storage at the lower of cost or market.
In general, commodity costs and variable transportation costs are capitalized as gas in underground storage. Fixed costs, primarily pipeline demand charges and storage charges, are expensed as incurred through cost of gas. Cost of Gas. The utility subsidiaries have gas cost recovery mechanisms which allow for the adjustment of rates charged to customers in response to increases and decreases in the cost of gas purchased. As permitted by the regulatory jurisdiction, increases or decreases in the cost of gas purchased are subsequently recovered from or refunded to customers. Income Taxes. Deferred income taxes are recorded for differences between the book and tax basis of certain assets and liabilities. Income tax expense includes Federal taxes currently payable and deferred income tax expenses resulting from adjustments to deferred income tax assets and liabilities. Investment tax credits (ITC) utilized in prior years for income tax purposes are deferred for financial accounting purposes and are amortized through credits to the income tax provision over the lives of the related property. The Company and its subsidiaries file a consolidated Federal income tax return. Income taxes are allocated to each subsidiary based on its separate taxable income. Statement of Cash Flows. For purposes of the consolidated statement of cash flows, the Company considers all highly liquid investments purchased with original maturities of three months or less to be cash and temporary cash investments.
2. REGULATORY MATTERS
MPSC Orders. In June 1994, pursuant to the MPSC securities orders U-10509 and U-10510, Southeastern and Michigan Gas issued $23,000,000 and $31,000,000, respectively, of long-term debt securities to the Company. This debt was used to redeem higher cost long-term and certain short-term debt owed to the Company and, in Southeastern's case, was also used to redeem all of its remaining first mortgage bonds. In December 1992, the MPSC issued Order U-10040 addressing the change in accounting for the cost of retiree medical benefits. Pursuant to this order, the utility subsidiaries plan to file generic rate cases before 1996 in order to recover certain expenses related to this change in accounting treatment. Any relief granted will be based on all elements of cost of service. Refer to Note 7 for further discussion regarding retiree medical benefits. In June 1994, the MPSC issued Orders U-10617 and U-10618 to Michigan Gas and Southeastern, respectively. These orders require the companies to offset deferred retiree medical costs with certain reductions in Michigan state property taxes until the MPSC issues a final order in a rate case filed pursuant to Order U-10040. In accordance with U-10617 and U-10618, Michigan Gas and Southeastern have reduced deferred retiree medical costs for $269,000 and $168,000, respectively.
In February 1993, the MPSC issued Opinion and Order U-10083 addressing the provisions of the MPSC Uniform System of Accounts for electric and gas utilities related to deferred income tax accounting. Refer to Note 3 for deferred income tax accounting discussion. Take-or-Pay. The take-or-pay liabilities of the utility subsidiaries arose pursuant to FERC actions involving deregulation of the natural gas industry. These costs are substantially recoverable from ratepayers. At December 31, 1994 and 1993, the Company's remaining take-or-pay liabilities totaled $351,000 and $1,475,000, respectively. The Company does not anticipate additional take-or-pay assessments. Order 636 Transition Costs. In 1992, the FERC issued Order 636 requiring interstate pipelines to unbundle their services to most customers and instead offer separate services for gas supply, gathering, transportation and storage. Pursuant to the implementation of Order 636 in 1993, the FERC authorized the interstate pipelines to directly bill certain transition costs to former sales service customers. As a result, the Company incurred and recorded liabilities of $2,014,000 at December 31, 1993. In 1994, the Company incurred and recorded $1,223,000 of additional liabilities and, at December 31, 1994, had $1,904,000 of recorded liabilities remaining. The Company does not anticipate any significant additional direct billings related to Order 636 transition costs. As with take-or-pay costs, Order 636 costs are substantially recoverable from ratepayers.
3. INCOME TAXES
SFAS No. 109. In January 1993, the Company prospectively adopted SFAS 109, "Accounting For Income Taxes." Previously, the Company accounted for income taxes under Accounting Principles Board Opinion No. 11. SFAS 109 requires an annual measurement of deferred tax assets and deferred tax liabilities based upon the estimated future tax effects of temporary differences and carryforwards. In general, the total deferred tax expense or benefit for the year equals the difference between the beginning and end of year balances in deferred tax assets and liabilities. In February 1993, the MPSC issued Opinion and Order U-10083 addressing deferred income tax accounting for electric and gas utilities under its jurisdiction. The order granted electric and gas utilities regulated by the MPSC general authorization to use deferred tax accounting and to use specific accounts to comply with SFAS 109. The order also confirmed continued recovery of regulatory assets and refunding of regulatory liabilities arising from deferred tax accounting through current ratemaking practices. Upon adoption, the initial application of SFAS 109 was determined by recomputing the balance sheet deferred tax amounts as of January 1, 1993 using currently enacted tax rates. The most significant adjustments were related to the Company's regulated operations and, since these adjustments are expected to be recovered from or refunded to customers in future rates, were offset on the balance sheet by regulatory assets and regulatory liabilities. As a result, the adoption of SFAS 109 had no material impact on the results of operations. SFAS 109 requires that deferred tax assets and deferred tax liabilities be adjusted for changes in tax rates. During 1993, the Company adjusted these items for a one percent increase in the enacted rate. There was no material impact to operations resulting from this adjustment. At December 31, 1994 and December 31, 1993 there was no valuation allowance recorded against deferred tax assets.
4. CAPITALIZATION
Common Stock Equity. The Company issued five percent stock dividends in May 1994, May 1993 and May 1992. Earnings per share of common stock, cash dividends per share of common stock and average number of common shares outstanding have been restated to reflect the stock dividends. Pursuant to its DRIP, the Company issued 307,000 shares of common stock in 1994, 247,000 shares in 1993, and 238,000 shares in 1992. In January 1995, the Company amended its DRIP to allow the Company to acquire common shares on the open market to meet the dividend reinvestment and optional payment requirements of the DRIP. Except to the extent that purchase of shares on the open market becomes difficult, the Company does not expect to issue new shares under the plan. In January 1994, the Company issued 747,500 shares of common stock pursuant to a shelf registration. Net proceeds of approximately $14,629,000 were used to reduce notes payable to banks incurred to finance the Company's ongoing capital expenditure program and for general corporate purposes. The Company has short-term credit arrangements and long-term debt indentures which contain, among other restrictions, limits on the payment of dividends beyond certain levels of retained earnings. Under the most restrictive of these covenants, all of the Company's retained earnings of $15,027,000 was available for the payment of dividends on any class of stock at December 31, 1994. Cumulative Convertible Preferred Stock. At December 31, 1994 and 1993, 7,505 and 7,605 shares of the Company's $2.3125 cumulative convertible preferred shares were outstanding and each share was convertible at the option of the holder to 4.11 shares of common stock. At December 31, 1994, 30,846 shares of common stock are reserved for issuance upon conversion to holders of the convertible preferred stock. In 1994, 1993 and 1992, preferred shares totalling 100, 1,186 and 500 were converted into 411, 4,873 and 2,055 shares of the Company's common stock, respectively.
Cumulative Preferred Stock of Subsidiary. The cumulative preferred stock of Southeastern is callable at Southeastern's option at $105 per share. Payment of dividends on Southeastern's preferred stock is fully guaranteed by the Company. Long-Term Debt. In 1994, the Company recorded an extraordinary charge of $1,286,000, net of tax, for the early extinguishment of its 9.8% debentures due 2014. In 1993, the Company also recorded an extraordinary charge of $177,000, net of tax, for the planned redemption of its 10% debentures, due 2007 and 2008, which occurred in February 1994. The Company completed the refinancing of its higher cost debt in 1994 by retiring the variable rate term loan due 1997 and all of Southeastern's outstanding first mortgage bonds. These redemptions were funded through the private placement of $55,000,000 of 10-year notes at 8.00% and $25,000,000 of 30-year notes at 8.32%. There are no annual maturities or sinking fund requirements for the Company's existing debt over the next five years.
5. SHORT-TERM BORROWINGS
The Company maintains unsecured lines of credit at two banks. Interest on all such lines are at variable rates, which do not exceed the banks' prime lending rates. These arrangements are set to expire during 1995 and the Company expects they will be renegotiated at comparable terms.
6. FINANCIAL INSTRUMENTS AND HEDGING ACTIVITIES
Financial Instruments. The following methods and assumptions were used to estimate the fair value of each significant class of financial instruments: Cash, temporary cash investments, trade payables and receivables, notes payable to banks, and variable rate long-term debt. The carrying amount approximates fair value. Long-term debt. The fair values of the Company's fixed-rate long-term debt are estimated based on quoted market prices for the same or similar issues or where no market quotes are available, based on discounted future cash flows using current interest rates at which similar loans would be made to borrowers with similar credit ratings and remaining maturities.
Hedging Activities. SEMCO enters into sales commitments which may extend up to 24 months into the future. Because of the volatility of natural gas prices, there are significant market risks associated with these commitments. To manage these risks, SEMCO maintains a hedging program. The primary objective of SEMCO's hedging program is to attempt to eliminate the effect of price fluctuations in the natural gas spot market on their extended sales commitments. SEMCO uses several mechanisms to hedge against this market risk. The most frequently used hedges are natural gas futures and options. SEMCO may also enter into natural gas swap agreements, contract to purchase natural gas from producers for future delivery or inject gas into storage for later withdrawal. Gains and losses on these transactions, accounted for as hedges, are included in revenues in the same period natural gas is delivered to customers pursuant to the underlying marketing contracts.
As of December 31, 1994, SEMCO also had outstanding natural gas swap agreements covering a notional amount of 16,663,000 Mcf. The estimated unrealized loss of these agreements, determined by market quotes, was $123,000 at December 31, 1994. There were no swap agreements outstanding in 1993. SEMCO also hedges certain of its sales commitments with gas held in storage. At December 31, 1994, SEMCO held approximately 3,053,000 Mcf in storage with a net carrying value of $6,666,000, which approximates fair value. SEMCO has deferred losses associated with this gas of $1,207,000, which is also recorded in other current assets. SEMCO did not hold any significant amounts of gas-in-storage at December 31, 1993.
7. PENSION PLANS AND OTHER POSTRETIREMENT BENEFITS
Pension Plans. The Company has non-contributory, defined benefit pension plans, covering substantially all employees. Pension plan benefits are generally based upon years of service and compensation during the final years
of employment. The Company's funding policy is to contribute amounts annually to the plans based upon actuarial and economic assumptions designed to achieve adequate funding of projected benefit obligations. The Company contributes at least the minimum required by the Employee Retirement Income Security Act of 1974, as amended. At December 31, 1994, plan assets consisted of 44.1% equity investments, 17.1% guaranteed income insurance contracts, 28.3% fixed income securities and 10.5% cash equivalents. The Company's pension expense was $2,261,000, $1,728,000 and $1,821,000 in the years 1994, 1993 and 1992, respectively.
Other Postretirement Benefits. In addition to providing pension benefits, the Company provides certain medical and prescription drug benefits to qualified retired employees, their spouses and covered dependents. To qualify, a retiree must have started employment before January 1, 1992 and have had at least ten years of service. Retirees with less than 30 years of service are required to contribute from 5% to 50% of the Company's coverage cost, with the percentage depending on the retiree's age and years of service. Employees hired after January 1, 1992 are not eligible for these benefits under the current plan. In December 1990, the FASB issued SFAS 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." The new standard requires the Company to change its method of accounting for the cost of retiree medical benefits that are provided to retirees from a pay-as-you-go (cash) method to a full accrual method. Accrual of such costs is required during the years that the employee renders service to the Company until the date of full eligibility. The Company adopted SFAS 106 effective January 1, 1993. In December 1992, the MPSC issued a generic order addressing the adoption of SFAS 106 by utilities under their jurisdiction. The order allows Michigan utilities to adopt SFAS 106 for accounting and ratemaking purposes, subject to a final order in a general rate case filed before 1996. The generic order requires external funding for amounts recovered in rates. The Company plans to file general rate cases in accordance with the order during 1995. Any rate relief granted will be based on all elements of cost of service, including this obligation.
In 1994 and 1993, the Company expensed net retiree medical costs of $951,000 and $841,000, respectively, consisting of total costs incurred under the pay-as-you-go method plus additional SFAS 106 costs recorded by the non-utility subsidiaries. In 1994, the Company also expensed $437,000 of SFAS 106 costs pursuant to certain MPSC orders regarding the reduction in Michigan state property taxes. See Note 2 for further discussion of these MPSC orders. The Company recorded regulatory assets related to the utility subsidiaries' SFAS 106 costs of $4,338,000 and $4,425,000 in 1994 and 1993, respectively. The Company funds retiree medical benefits on a discretionary basis through an Internal Revenue Code Section 401(h) account. In 1993 and 1992, the Company made cash contributions to the 401(h) account of $579,000 and $314,000, respectively. No contributions were made to the 401(h) account in 1994.
The 1994 costs were developed based on the substantive health care plan in effect at January 1, 1994. As of December 31, 1994, the actuary assumed that retiree medical cost increases would be 11.5% in 1994, 11.1% in 1995, and decrease uniformly to 6.8% in 2005 and thereafter and that prescription drug cost increases would be 15.2% in 1994, 14.5% in 1995, and decrease uniformly to 6.8% in 2005 and thereafter. The health care cost trend rate assumption significantly affects the amounts reported. For example, a one percentage point increase in each year would increase the accumulated retiree medical obligation as of December 31, 1994 by $7,950,000 and the aggregate of the service and interest cost components of net periodic retiree medical costs for 1994 by $1,001,000. Employee Stock Ownership Trust. The Company has an employee stock ownership trust (ESOT) which covers substantially all employees. Under the provisions of this trust, the Company may contribute an annual amount at its discretion for the benefit of eligible employees. The contribution, if any, may be made in cash or in common shares of the Company. For the years 1994, 1993 and 1992, the Company's contributions were $600,000, $600,000 and $400,000, respectively. In December 1988, the trust borrowed $4,000,000 under a term loan to purchase 274,348 shares of the Company's common stock. In accordance with applicable accounting rules, the Company recorded the ESOT indebtedness in long-term debt on its balance sheet with an offsetting charge to common stock equity captioned "Unearned compensation-ESOT." The amount of dividends on ESOT shares used by the trust to pay debt service in 1993 and 1992 were $185,000 and $675,000, respectively. Interest expense incurred by the trust in those years was $5,000 and $45,000, respectively. The ESOT term loan was paid in full in 1993.
8. COMMITMENTS AND CONTINGENCIES
Construction Program. The Company's plans for expansion and improvement of its distribution and transmission system, as well as other operations, are under a process of continuing review. Aggregate capital expenditures for all segments of the Company's operations for 1995 are projected at $24,780,000. Certain commitments have been made in connection with these expenditures. Guarantees. SEMCO Arkansas Pipeline Company, a wholly-owned subsidiary of SEMCO, has a 32% interest in a partnership which operates the NOARK Pipeline System (NOARK). NOARK is a 302-mile intrastate natural gas pipeline, originating in northwest Arkansas and extending northeast across the state. The pipeline became operational during the third quarter of 1992. The Company, SEMCO Arkansas Pipeline Company and SEMCO have guaranteed 40% of the principal and interest payments on approximately $89,400,000 of debt used to finance the pipeline. Of the total debt, $59,850,000 is outstanding pursuant to a long-term arrangement requiring annual principal payments of approximately $3,150,000 together with interest on the unpaid balance. This arrangement matures in 2009 and has a fixed interest rate of 9.7375%. The remaining debt is pursuant to a $30,000,000 multibank revolving line of credit which currently matures April 26, 1997. Under the terms of the credit agreement, NOARK may request, on an annual basis, a one year extension of the then-effective termination date. At December 31, 1994, NOARK had $29,550,000 outstanding under the agreement with interest payments at a variable interest rate. NOARK has been operating below capacity and generating losses since it was placed in service. The pipeline experienced significant cost overruns during construction which resulted in higher financing costs than expected. Competition from two interstate pipelines in the Arkansas region has required NOARK to discount its transportation charges to attract volumes to the pipeline. In addition, on January 1, 1994, a major shipper of firm volumes on the NOARK system discontinued shipments of gas under its contract and ceased payment of the firm demand fee pursuant to legal action. In December 1993, Vesta Energy Corporation (Vesta), a firm shipper on NOARK, filed a complaint in the Federal District Court for the Northern District of Oklahoma against seven defendants, including NOARK. Vesta sought actual damages on several theories in an aggregate amount exceeding $1,000,000, sought punitive damages in excess of $1,000,000 and sought to rescind its contracts with certain defendants, including its firm transportation contract with NOARK. Under the terms of Vesta's 50,000 Mcf per day contract with NOARK, Vesta is obligated to pay full firm rates which consist of a demand fee of approximately 19.3 cents per Mcf on 50,000 Mcf per day and approximately 9.2 cents per Mcf for volumes actually transported on the NOARK system. This contract is set to expire in 1997. In February 1994, the defendants, including NOARK, filed a motion for dismissal of Vesta's claim due to lack of Federal jurisdiction in the Oklahoma court. In addition, NOARK and certain other defendants filed separate claims in Arkansas against Vesta for breach of contract. In June 1994, the Oklahoma court dismissed Vesta's case. In January 1995, Vesta filed a counterclaim and third party complaint in the Federal District Court for the Western District of Arkansas against twelve defendants, including NOARK and SEMCO Arkansas Pipeline
Company. Vesta seeks both punitive and actual damages each in excess of $1,000,000 and seeks to be excused from performance under its contracts with certain defendants, including NOARK. Vesta alleges it was fraudulently induced into such contracts and also seeks relief pursuant to federal and state antitrust statutes and other state laws. The Company does not expect that the January 1995 action by Vesta against SEMCO Arkansas Pipeline Company will have a significant negative impact on the Company's results of operation. As these circumstances continue, NOARK's operating cash flows will be insufficient to meet debt service requirements. Principally subject to ultimate resolution of the above legal actions, the Company estimates a net cash outflow in the range of $1,500,000 to $2,000,000 during 1995 related to its investment in NOARK and the guarantee. The Company contributed $906,000 to NOARK pursuant to the guarantee in October 1994 and $760,000 in January 1995. The NOARK partners are currently investigating several options available to NOARK. Management continues to believe that no write-down of its investment in NOARK is appropriate at this time. Therefore, no provision for any loss has been made in the accompanying financial statements.
9. INVESTMENTS IN AFFILIATES
The equity method of accounting is used for interests the Company holds in affiliates 20% to 50% owned or in which the Company has significant influence over operations. These affiliate companies are generally involved in natural gas transmission, storage, or associated operations. The Company provides income taxes on its share of undistributed earnings of these subsidiaries at the time the earnings are included in consolidated income. Refer to Note 8 for a discussion of the Company's significant guarantees of affiliate debt.
10. QUARTERLY FINANCIAL INFORMATION (Unaudited)
In the opinion of the Company, the following quarterly information includes all adjustments necessary for a fair statement of the results of operations for such periods. Earnings and dividends per share of common stock are calculated based upon the weighted average number of shares outstanding during each quarter. Due to the seasonal nature of the Company's gas distribution business, the results of operations reported on a quarterly basis show substantial variations.
ARTHUR ANDERSEN LLP
Report of Independent Public Accountants
To Southeastern Michigan Gas Enterprises, Inc.:
We have audited the accompanying consolidated balance sheets and statements of capitalization of SOUTHEASTERN MICHIGAN GAS ENTERPRISES, INC. (a Michigan corporation) and subsidiaries as of December 31, 1994 and 1993, and the related consolidated statements of income, changes in stockholders' investment and cash flows for each of the three years in the period ended December 31, 1994. 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 consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Southeastern Michigan Gas Enterprises, Inc. and subsidiaries as of December 31, 1994 and 1993, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1994, in conformity with generally accepted accounting principles.
As discussed in Notes 3 and 7 to the consolidated financial statements, effective January 1, 1993, the Company changed its method of accounting for income taxes and other postretirement 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 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 LLP
Detroit, Michigan, February 8, 1995.
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 appearing under the captions "Information About Directors and Executive Officers" and "Other Executive Officers" in Registrant's definitive Proxy Statement (filed pursuant to Regulation 14A) with respect to Registrant's April 18, 1995 Annual Meeting of Shareholders is incorporated by reference herein.
ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION
The information appearing under the captions "Compensation Committee Interlocks and Insider Participation" and "Compensation of Directors and Executive Officers" in Registrant's definitive Proxy Statement (filed pursuant to Regulation 14A) with respect to Registrant's April 18, 1995 Annual Meeting of Shareholders is incorporated by reference herein.
ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information appearing under the caption "Stock Outstanding, Voting Rights and Votes Required" in the Registrant's definitive Proxy Statement (filed pursuant to Regulation 14A) with respect to Registrant's April 18, 1995 Annual Meeting of Shareholders, is incorporated by reference herein.
ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information appearing under the caption "Certain Business Relationships of Directors" in the Registrant's definitive Proxy Statement (filed pursuant to Regulation 14A) with respect to Registrant's April 18, 1995 Annual Meeting to Shareholders, is incorporated by reference herein.
PART IV
ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
Key to Exhibits Incorporated by Reference
(a) Filed with Enterprises' Form 10-K for 1989, dated March 29, 1990, File No. 0-8503. (b) Filed with Enterprises' Form 10-K for 1990, dated March 28, 1991, File No. 0-8503. (c) Filed with Enterprises' Registration Statement, Form S-2, No. 33-46413, filed March 16, 1992. (d) Filed with Enterprises' Form 10-K for 1991, dated March 27, 1992, File No. 0-8503. (e) Filed with Enterprises' Form 10-Q for the quarter ended March 31, 1992, File No. 0-8503. (f) Filed with Enterprises' Form 10-K for 1992, dated March 30, 1993, File No. 0-8503. (g) Filed with Enterprises' Form 10-Q for the quarter ended June 30, 1994, File No. 0-8503. (h) Filed with Enterprises' Form 10-Q for the quarter ended September 30, 1994, File No. 0-8503. (i) Filed March 20, 1995, pursuant to Rule 14a-6 of the Exchange Act, File No. 0-8503.
ITEM 14. (Continued)
(b) No reports on Form 8-K have been filed during the quarter ended December 31, 1994.
(c) The Exhibits, if any, filed herewith are identified on the Exhibit Index.
(d) The financial statement schedules filed are listed under Item 14.(a).2. above.
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.
SOUTHEASTERN MICHIGAN GAS ENTERPRISES, INC.
Date: March 28, 1995 By Ward N. Kirby President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Signature Title Date --------- ----- ----
Ward N. Kirby President March 28, 1995 (Director and Principal Executive Officer)
Robert F. Caldwell Executive Vice President March 28, 1995 (Director)
Marcia M. Chmielewski Vice President, Treasurer and March 28, 1995 Chief Financial Officer (Principal Financial and Accounting Officer)
Frank G. Andreoni* Director March 28, 1994
Daniel A. Burkhardt* Director March 28, 1994
John T. Ferris* Director March 28, 1994
Michael O. Frazer* Director March 28, 1994
Harvey I. Klein* Director March 28, 1994
William March* Director March 28, 1994
Edith A. Stotler* Director March 28, 1994
Robert J. Thomson* Director March 28, 1994
John W. Wirtz* Director March 28, 1994
*By Ward N. Kirby March 28, 1994 Attorney-in-fact
SCHEDULE I
SOUTHEASTERN MICHIGAN GAS ENTERPRISES, INC. SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF SOUTHEASTERN MICHIGAN GAS COMPANY
SCHEDULE I (cont.) SOUTHEASTERN MICHIGAN GAS ENTERPRISES, INC. SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF SOUTHEASTERN MICHIGAN GAS COMPANY
SCHEDULE I (cont.) SOUTHEASTERN MICHIGAN GAS ENTERPRISES, INC. SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF SOUTHEASTERN MICHIGAN GAS COMPANY
SCHEDULE I (cont.) SOUTHEASTERN MICHIGAN GAS ENTERPRISES, INC. SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF SOUTHEASTERN MICHIGAN GAS COMPANY
SCHEDULE II
SOUTHEASTERN MICHIGAN GAS ENTERPRISES, INC. Exhibit Index Form 10-K
Key to Exhibits Incorporated by Reference
(a) Filed with Enterprises' Form 10-K for 1989, dated March 29, 1990, File No. 0-8503. (b) Filed with Enterprises' Form 10-K for 1990, dated March 28, 1991, File No. 0-8503. (c) Filed with Enterprises' Registration Statement, Form S-2, No. 33-46413, filed March 16, 1992. (d) Filed with Enterprises' Form 10-K for 1991, dated March 27, 1992, File No. 0-8503. (e) Filed with Enterprises' Form 10-Q for the quarter ended March 31, 1992, File No. 0-8503. (f) Filed with Enterprises' Form 10-K for 1992, dated March 30, 1993, File No. 0-8503. (g) Filed with Enterprises' Form 10-Q for the quarter ended June 30, 1994, File No. 0-8503. (h) Filed with Enterprises' Form 10-Q for the quarter ended September 30, 1994, File No. 0-8503. (i) Filed March 20, 1995, pursuant to Rule 14a-6 of the Exchange Act, File No. 0-8503.