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

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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 1. BUSINESS SOUTHERN was incorporated under the laws of Delaware on November 9, 1945. SOUTHERN is domesticated under the laws of Georgia and is qualified to do business as a foreign corporation under the laws of Alabama. SOUTHERN owns all the outstanding common stock of ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH, each of which is an operating public utility company. ALABAMA and GEORGIA each own 50% of the outstanding common stock of SEGCO. The operating affiliates supply electric service in the states of Alabama, Georgia, Florida, Mississippi and Georgia, respectively, and SEGCO owns generating units at a large electric generating station which supplies power to ALABAMA and GEORGIA. More particular information relating to each of the operating affiliates is as follows: ALABAMA is a corporation organized under the laws of the State of Alabama on November 10, 1927, by the consolidation of a predecessor Alabama Power Company, Gulf Electric Company and Houston Power Company. The predecessor Alabama Power Company had had a continuous existence since its incorporation in 1906. GEORGIA was incorporated under the laws of the State of Georgia on June 26, 1930, and admitted to do business in Alabama on September 15, 1948. GULF is a corporation which was organized under the laws of the State of Maine on November 2, 1925, and admitted to do business in Florida on January 15, 1926, in Mississippi on October 25, 1976 and in Georgia on November 20, 1984. MISSISSIPPI was incorporated under the laws of the State of Mississippi on July 12, 1972, was admitted to do business in Alabama on November 28, 1972, and effective December 21, 1972, by the merger into it of the predecessor Mississippi Power Company, succeeded to the business and properties of the latter company. The predecessor Mississippi Power Company was incorporated under the laws of the State of Maine on November 24, 1924, and was admitted to do business in Mississippi on December 23, 1924, and in Alabama on December 7, 1962. SAVANNAH is a corporation existing under the laws of Georgia; its charter was granted by the Secretary of State on August 5, 1921. SOUTHERN also owns all the outstanding common stock of SEI, Southern Nuclear, SCS (the system service company), and various other subsidiaries related to foreign operations and domestic non-utility operations (see Exhibit 21 herein). At this time, the operations of the other subsidiaries are not material. SEI designs, builds, owns and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. A further description of SEI's business and organization follows later in this section. Southern Nuclear provides services to the Southern electric system's nuclear plants. SEGCO owns electric generating units with an aggregate capacity of 1,019,680 kilowatts at Plant Gaston on the Coosa River near Wilsonville, Alabama, and ALABAMA and GEORGIA are each entitled to one-half of SEGCO's capacity and energy. ALABAMA acts as SEGCO's agent in the operation of SEGCO's units and furnishes coal to SEGCO as fuel for its units. SEGCO also owns three 230,000 volt transmission lines extending from Plant Gaston to the Georgia state line at which point connection is made with the GEORGIA transmission line system. THE SOUTHERN SYSTEM The transmission facilities of each of the operating affiliates and SEGCO are connected to the respective company's own generating plants and other sources of power and are interconnected with the transmission facilities of the other operating affiliates and SEGCO by means of heavy-duty high voltage lines. (In the case of GEORGIA's integrated transmission system, see Item 1 - BUSINESS - "Territory Served" herein.) Operating contracts covering arrangements in effect with principal neighboring utility systems provide for capacity exchanges, capacity purchases and sales, transfers of economy energy and other similar transactions. Additionally, the operating affiliates have entered into voluntary reliability agreements with the subsidiaries of Entergy Corporation, Florida Electric Power Coordinating Group and TVA and with Carolina Power & Light Company, Duke Power Company, South Carolina Electric & Gas Company and Virginia Electric I-1 and Power Company, each of which provides for the establishment and periodic review of principles and procedures for planning and operation of generation and transmission facilities, maintenance schedules, load retention programs, emergency operations, and other matters affecting the reliability of bulk power supply. The operating affiliates have joined with other utilities in the Southeast (including those referred to above) to form the SERC to augment further the reliability and adequacy of bulk power supply. Through the SERC, the operating affiliates are represented on the National Electric Reliability Council. An intra-system interchange agreement provides for coordinating operations of the power producing facilities of the operating affiliates and SEGCO and the capacities available to such companies from non-affiliated sources and for the pooling of surplus energy available for interchange. Coordinated operation of the entire interconnected system is conducted through a central power supply coordination office maintained by SCS. The available sources of energy are allocated to the operating affiliates to provide the most economical sources of power consistent with good operation. The resulting benefits and savings are apportioned among the operating affiliates. SCS has contracted with each operating affiliate, SEI, various of the other subsidiaries, Southern Nuclear and SEGCO to furnish, at cost and upon request, the following services: general executive and advisory services, power pool operations, general engineering, design engineering, purchasing, accounting and statistical, finance and treasury, taxes, insurance and pensions, corporate, rates, budgeting, public relations, employee relations, systems and procedures and other services with respect to business and operations. SOUTHERN also has a contract with SCS for certain of these specialized services. Southern Nuclear has contracted with ALABAMA to operate its Farley Nuclear Plant, as authorized by amendments to the plant operating licenses. Southern Nuclear also has a contract to provide GEORGIA with technical and other services to support GEORGIA's operation of plants Hatch and Vogtle. Applications are now pending before the NRC for amendments to the Hatch and Vogtle operating licenses which would authorize Southern Nuclear to become the operator. See Item 1 - BUSINESS - "Regulation - Atomic Energy Act of 1954" herein. NEW BUSINESS DEVELOPMENT SOUTHERN continues to consider new business opportunities, particularly those which allow use of the expertise and resources developed through its regulated utility experience. These endeavors began in 1981 and are conducted through SEI and other existing subsidiaries. SEI's primary business focus is international and domestic cogeneration, the independent power market, and the privatization of generation facilities in the international market. SEI currently operates two domestic independent power production projects totaling 225 megawatts and is one-third owner of one of these (which produces 180 megawatts). It has a contract to sell electric energy to Virginia Electric and Power Company from a facility SEI is developing (through subsidiaries) in King George, Virginia. Upon completion, currently planned for 1996, SEI will operate the 220 megawatt coal-fired plant and own 50% of the project. In April 1993, SOUTHERN completed the purchase of a 50% interest in Freeport, an electric utility on the Island of Grand Bahama, for a purchase price of $35.5 million. Freeport has generating capacity of about 112 megawatts. In August 1993, SOUTHERN completed the purchase of a 55% interest in Alicura, an entity that owns the right to use the generation from a 1,000 megawatt hydroelectric generating facility in Argentina, for a net purchase price of approximately $188 million. In December 1993, SOUTHERN completed the purchase of a 35% interest in Edelnor for the purchase price of $73 million. Edelnor is a utility located in Northern Chile that owns and operates a transmission grid and a 96 megawatt generating facility and is building an additional 150 megawatt facility. SEI has continued to render consulting services and market SOUTHERN system expertise in the United States and throughout the world. It contracts with other public utilities, commercial concerns and government agencies for the rendition of services and the licensing of intellectual property. In addition, SEI engages in energy management-related services and activities. These continuing efforts to invest in and develop new business opportunities offer the potential of earning returns which may exceed those of rate-regulated operations. However, because of the absence of any assured return or rate of return, they also involve a higher I-2 degree of risk. SOUTHERN expects to make substantial investments over the period 1994-1996 in these and other new businesses. CERTAIN FACTORS AFFECTING THE INDUSTRY The electric utility industry is expected to become increasingly competitive in the future as a result of the enactment of the Energy Act (see each registrant's "Management's Discussion and Analysis - Future Earnings Potential" in Item 7 herein), deregulation, competing technologies and other factors. In recent years the electric utility industry in general has experienced problems in a number of areas including the uncertain cost of capital needed for construction programs, difficulty in obtaining sufficient return on invested capital and in securing adequate rate increases when required, high costs and other issues associated with compliance with environmental and nuclear regulations, changes in regulatory climate, prudence audits and the effects of inflation and other factors on the costs of operations and construction expenditures. The SOUTHERN system has been experiencing certain of these problems in varying degrees and management is unable to predict the future effect of these or other factors upon its operations and financial condition. CONSTRUCTION PROGRAMS The subsidiary companies of SOUTHERN are engaged in continuous construction programs to accommodate existing and estimated future loads on their respective systems. Construction additions or acquisitions of property during 1994 through 1996 by the operating affiliates, SEGCO, SCS and Southern Nuclear are estimated as follows: (in millions) *Does not add due to changes made in subsidiaries' construction budget subsequent to approval of SOUTHERN system construction budget. Reference is made to Note 4 to the financial statements of each registrant in Item 8 herein for the amounts of AFUDC included in the above estimates. The construction estimates for the period 1994 through 1996 do not include amounts which may be spent by SEI (or the subsidiary(s) created to effect such project(s)) on future power production projects or the projects discussed earlier under "New Business Development." (See also Item 1 - BUSINESS - "Financing Programs" herein.) I-3 Estimated construction costs in 1994 are expected to be apportioned approximately as follows: (in millions) *SCS and Southern Nuclear plan capital additions to general plant in 1994 of $26 million and $1 million, respectively, while SEGCO plans capital additions of $14 million to generating facilities. Does not add due to changes made in subsidiaries' construction budget subsequent to approval of SOUTHERN system construction budget. The construction programs are subject to periodic review and revision, and actual construction costs may vary from the above estimates because of numerous factors. These factors include changes in business conditions; revised load growth estimates; changes in environmental regulations; changes in existing nuclear plants to meet new regulatory requirements; increasing cost of labor, equipment and materials; cost of capital and SEI securing a contract(s) to buy or build additional generating facilities. The operating affiliates do not have any baseload generating plants under construction and current energy demand forecasts do not require any additional baseload generating facilities before 2011. However, within the service area, the construction of combustion turbine peaking units with an aggregate capacity of approximately 1,700 megawatts is planned to be completed by 1996. In addition, significant construction of transmission and distribution facilities and upgrading of generating plants will be continuing. During 1991, the Georgia legislature passed legislation which requires GEORGIA and SAVANNAH each to file an Integrated Resource Plan for approval by the Georgia PSC. Under the plan rules, the Georgia PSC must pre-certify the construction of new power plants. (See Item 1 - BUSINESS - "Rate Matters - Integrated Resource Planning" herein.) See Item 1 - BUSINESS - "Regulation - Environmental Regulation" herein for information with respect to certain existing and proposed environmental requirements and Item 2

ITEM 1. BUSINESS. Gilbert Associates, Inc. (the "registrant") was organized as a holding company in 1984. Through its operating subsidiaries, the largest of which is Gilbert/Commonwealth, Inc. ("G/C"), the registrant is engaged in the businesses of providing engineering and consulting services and the manufacture and sale of communication equipment. G/C, formerly known as "Gilbert Associates, Inc." was organized in 1942. The registrant and its subsidiaries are sometimes referred to herein collectively as the "Gilbert companies." The holding company structure separates the administrative and financing activities of the registrant from the activities of its operating subsidiaries. The revenues, operating profits and identifiable assets of the registrant's engineering and consulting services and communication equipment segments for each of the last three years are stated in Note 14 to the consolidated financial statements contained in Part II, Item 8 of this report. ENGINEERING AND CONSULTING SERVICES The engineering and consulting services business segment consists of the registrant's largest subsidiary, G/C, and its subsidiaries, together with United Energy Services Corporation ("UESC"), Resource Consultants, Inc. ("RCI") and SRA Technologies, Inc. ("SRA"), wholly- owned subsidiaries of the registrant. The operations of these subsidiaries have been consolidated for reporting purposes. G/C, based in Reading, Pennsylvania, provides a wide range of engineering and consulting services, including electrical, mechanical, structural and nuclear engineering, construction management, procurement, and consulting services. G/C's major services are the design, engineering and supervision of the construction of electric power generating stations and electric transmission and distribution systems as well as upgrading and retrofitting existing power plants. It also renders services to industrial clients and various governmental agencies. UESC primarily provides operations and engineering consulting services to the electric power generation industry. RCI provides engineering, outplacement services, technical and other program support services to U.S. defense agencies, principally the U.S. Navy and Army and other U.S. Government agencies. Effective December 10, 1993, the registrant acquired all of the outstanding capital stock of SRA Technologies, Inc. for $6,500,000 in cash. The registrant also paid $1,500,000 in cash for other intangible assets, which resulted in a total purchase price of $8,000,000. SRA provides research and consulting services in life and environmental sciences, engineering and related technical areas. There were no other significant new business developments relating to the engineering and consulting segment during the fiscal year ended December 31, 1993.* * All references to particular years in the balance of this Report refer to the fiscal year ended on or about December 31 of such year. Thus, the fiscal year ended December 31, 1993 is from time to time referred to as simply "1993" elsewhere in this Report. The services of G/C and UESC in the engineering and consulting industry are not divisible into classes because the projects undertaken by G/C and UESC require the utilization, in varying proportions depending upon the project, of the skills and talents of staff members who are qualified in a variety of disciplines. For example, a single project may involve the utilization of the services of mechanical engineers, electrical engineers, structural engineers, draftspeople, clerical personnel and others. The following table sets forth for the past three fiscal years the revenues derived from the listed categories of engineering and consulting services rendered. Engineering and Consulting Revenues (in thousands of dollars) 1993 1992 1991 Design and Related Services $123,945 $127,844 $142,234 Operations Services 61,834 85,351 61,874 Defense Related Services 57,624 51,027 35,801 Operating profit and identifiable assets for the last three years within the engineering and consulting segment are disclosed in Note 14 to the consolidated financial statements in Part II, Item 8 of this report. The following table sets forth the approximate percentage of operating revenues derived from the principal markets served by the engineering and consulting segment during 1993 and the approximate percentage of backlog as of December 31, 1993 represented by work arrangements with clients in such markets: Percentage of Percentage of Backlog Market for Services 1993 Revenues as of December 31, 1993 U.S. Private Industry 42% 11% U.S. Federal, State and Local Governments and Agencies 52 87 Foreign Governments and Businesses 6 2 The work arrangements of this segment, while varying, are essentially either cost-plus or fixed-price. G/C, UESC, RCI and SRA have limited the number and extent of their fixed-price commitments in light of their experience that extended periods of performance and changes in governmental requirements tend to make it difficult to make adequate allowance for escalation and contingencies in fixed-price quotations. The majority of the Gilbert companies' engineering and consulting revenues was attributable to contracts other than fixed-price arrangements in each of the last three years. In addition, fixed-price contracts represent less than a majority of the backlog attributable to such segment at December 31, 1993. The ability to continue to sell services on a basis other than fixed-price will, however, depend upon a number of factors including the state of the national economy, the level of actual and planned capital and operating expenditures by prospective clients, and the trend of contracting practices in the markets in which such services are rendered. Inventory is not essential to the operations of the Gilbert companies' engineering and consulting segment. The subsidiaries comprising the Gilbert companies' engineering and consulting segment own various patents and trademarks and have pending applications for other patents. However, such patents and trademarks are not individually or cumulatively significant to the business of such segment. Although the engineering and consulting segment is not dependent upon any single client, its five largest clients have generally accounted for approximately one-half of its total revenues. During 1993, the United States Government and the Tennessee Valley Authority ("TVA") accounted for 24% and 16%, respectively, of total engineering and consulting revenues. During 1992, the United States Government and TVA accounted for 20% and 10%, respectively, of total engineering and consulting revenues. These amounts represent revenue earned by the registrant as prime contractor. No other client or its affiliate accounted for 10% or more of such revenues in 1993 or 1992. A substantial portion of the business of the engineering and consulting segment is obtained from clients served for a number of years. In the years 1993 and 1992, services rendered to clients who had been served at least four years earlier accounted for 83% and 81%, respectively, of the Gilbert companies' engineering and consulting revenues. There is no assurance that work authorizations from such clients will account for a similar percentage of total revenues in the future. As of December 31, 1993 and January 1, 1993, respectively, the subsidiaries comprising the Gilbert companies' engineering and consulting segment had backlogs of contracts or work authorizations from which they had then anticipated estimated aggregate future revenues of approximately $407,000,000 and $308,000,000. The backlog of RCI and SRA accounted for approximately 77% of the total segment backlog at December 31, 1993. The backlog of RCI accounts for 54% of the total backlog of the engineering and consulting segment at January 1, 1993. Substantially all of the backlog of RCI at such dates and SRA as of December 31, 1993 represents work to be performed on government contracts for which funding has not yet been authorized. Such funding authorizations are generally issued by the government in periodic increments during the contract term. The subsidiaries comprising the engineering and consulting segment anticipate that approximately $133,000,000 of the revenues to be recognized by them under work authorizations outstanding at December 31, 1993 will be earned within the fiscal year ending December 30, 1994 and that additional revenues will be earned in 1994 from work authorizations received during the year. Consistent with standard industry practice for professional service organizations, work authorizations for the Gilbert companies' engineering and consulting segment are terminable by their clients upon relatively brief notice, whether by the express terms of such work authorizations or otherwise. The completion dates for a number of projects have been extended in the past, thereby lengthening the period of time during which the backlog of estimated revenues for those projects was to be earned. With the continued unsettled conditions in the engineering and consulting industry, it is possible that one or more projects included in the backlog at December 31, 1993 might be extended or even cancelled. Work authorizations from the largest client included in such backlog total $143,000,000 for work on several U.S. Navy programs, of which $130,000,000 is subject to government funding. Since the majority of the operating costs of the subsidiaries comprising the Gilbert companies' engineering and consulting segment are payroll and payroll-related costs, and since their business is dependent upon the reputation and experience of their personnel, the quality of the services they render and their ability to maintain an organization which is qualified and adequately staffed to undertake and efficiently discharge assignments in the various fields in which such subsidiaries render services, a reasonable backlog is important for the scheduling of their operations and for the maintenance of a reasonably staffed level of operations. To the best of the knowledge of the registrant, no reliable data are available with respect to the total size of the market for engineering and consulting services for the full range of fields in which the registrant's subsidiaries are engaged. The registrant's engineering and consulting subsidiaries compete with a number of firms in each of the fields in which they are active, and some of their competitors have substantially larger total revenues, greater financial resources and more diversified businesses. Competition is based primarily on quality, reputation, experience and available skills and services. Frequently, however, formal or informal bidding procedures result in price competition. In terms of the number of employees rendering professional engineering and related services (excluding those incident to construction and technician services), the registrant believes that its engineering and consulting segment is one of the largest firms, but it is unable to determine its relative size within this group. Moreover, since there are a great many firms rendering similar services as a portion of their businesses or to affiliated companies only, the registrant believes it does not constitute a substantial part of the total market for such services. A number of the engineering and consulting segment's clients utilize their own staffs to do all or a major part of their own engineering work. Thus, the future business of the engineering and consulting segment of the Gilbert companies will be affected by the extent to which clients and potential clients utilize the services of outside engineering and consulting firms. Such future business will also be affected by the rate of growth of the electric utility industry, the demand for new power generation facilities, and the level of expenditure for capital goods in the United States. Reductions in United States government defense expenditures have recently been made and further reductions may follow. Although the registrant has not been adversely affected by these events, it is unable to estimate the degree or nature of the impact of any such reductions on the engineering and consulting segment. The Energy Policy Act of 1992, which became law in October 1992, includes various provisions which are expected to result in further deregulation of, and competition within, the electric utility industry and development of independent power production facilities. The effect of these provisions on the registrant's business is not certain. In addition, the Act contains amendments to the Atomic Energy Act designed to provide for standardization of nuclear plant designs and to otherwise simplify the nuclear power plant licensing process and thereby encourage development of nuclear power reactors by utilities. No new nuclear power plants have been ordered by utilities since 1978, and the effect of these amendments to the Atomic Energy Act on the registrant's business is considered to be uncertain pending satisfactory resolution of nuclear waste disposal issues. The registrant's engineering and consulting subsidiaries do not engage in any material company-sponsored research activities relating to the development of new products or services or the improvement of existing products or services. In the process of performing engineering and consulting services, some personnel of such subsidiaries are periodically involved in customer-sponsored research activities for the improvement of products or services, but few employees are engaged in such activities on a full-time basis and they are not a material part of the Gilbert companies' engineering and consulting business. On December 31, 1993, the engineering and consulting segment had a total of 3,428 employees, of which 2,459 employees were professional and technical personnel. In comparison, such segment had a total of 3,253 employees on January 1, 1993, of which 2,567 employees were professional and technical personnel. COMMUNICATION EQUIPMENT The communication equipment segment of the business of the Gilbert companies consists of the sale and customizing of communications equipment and related systems by GAI-Tronics Corporation ("GAI- Tronics"), a wholly-owned subsidiary of the registrant. GAI-Tronics is principally engaged in the development, assembly and marketing of communication and radio-controlled systems for industrial operations. In serving such customers, GAI-Tronics provides custom services by adapting communications systems to operate under extraordinary plant conditions such as excessive dust and explosive atmospheres. The value of orders for GAI-Tronics' systems may range from a minimal amount to several hundred thousand dollars. GAI-Tronics' significant class of products or services is the design and assembly of communication and radio-controlled systems. Effective December 28, 1993, GAI-Tronics acquired the net assets of Instrument Associates, Inc. (IAI), for $5,704,000 in cash plus an additional amount to be paid based upon the achievement of certain earnings objectives. Any additional amount will increase excess cost over equity in net assets and will not exceed $1,000,000. IAI designs and manufactures land mobile radio communications devices. There were no other significant new business developments relating to GAI-Tronics during 1993. The approximate percentage of GAI-Tronics' sales derived from the principal markets for its products during 1993 and the approximate percentage of its backlog as of December 31, 1993 represented by contracts with clients in such markets, were as follows: Percentage of Percentage of Backlog Market for Products 1993 Revenues as of December 31, 1993 U.S. Private Industry 80% 73% Foreign Governments and Businesses 20 27 Revenue, operating profit and identifiable assets for the last three years within the communications equipment segment are disclosed in Note 14 to the consolidated financial statements in Part II, Item 8 of this report. GAI-Tronics is continually modifying its products and attempting to further expand its product line. GAI-Tronics manufactures relatively few of the basic components employed in its equipment; instead, it primarily designs and assembles its equipment and systems by use of standard or special components manufactured by others. Several sources of supply exist for such components so that GAI-Tronics is not dependent upon any single supplier. GAI-Tronics maintains a substantial inventory of components to satisfy its customers' requirements because GAI-Tronics provides mainly customized communication systems for specialized uses. GAI-Tronics owns various patents and trademarks. However, such patents and trademarks are of less significance to GAI-Tronics' operations than its experience and reputation. GAI-Tronics' business is not dependent upon a single customer or a very few customers. An insubstantial amount of GAI-Tronics' sales in 1993 were made for installation in projects or to customers for which subsidiaries comprising the engineering and consulting segment had served as consulting engineer. (See "Business - Engineering and Consulting Services".) A substantial part of GAI-Tronics' business is obtained from customers to whom it has made previous sales. In 1993 and 1992, sales made to customers who had made purchases at least four years earlier accounted for approximately 94% of GAI-Tronics' total net sales. There is no assurance that sales from such customers will account for a similar percentage of total revenues in the future. Many of GAI- Tronics' sales are made as a result of proposals submitted in response to competitive bidding invitations. As of December 31, 1993 and January 1, 1993, GAI-Tronics had a backlog of contracts from which it had anticipated estimated future revenue of approximately $6,850,000 and $7,079,000, respectively. GAI-Tronics anticipates that substantially all of the goods reflected in its backlog at December 31, 1993, will be shipped in 1994. GAI- Tronics anticipates that the vast majority of its revenues earned in 1994 will be from orders received during the year. GAI-Tronics competes with a number of other organizations that develop and market specialized telephonic and communications systems. Some of its competitors have larger total sales, greater financial resources, larger research and development organizations and facilities and a more diversified range of communications services and products. GAI-Tronics' management believes that GAI-Tronics' history of quality, its reputation, experience and service are the most important factors in its being asked to submit bids and in purchasing decisions made by its customers. GAI-Tronics spent approximately $1,734,000, $1,309,000 and $1,596,000 during 1993, 1992 and 1991, respectively, on company- sponsored product development and improvement. Several of GAI- Tronics' professional employees routinely engage in company-sponsored product development and improvement on a full-time basis. GAI-Tronics has not made material expenditures on product development and improvement projects sponsored by customers in the last three years. On December 31, 1993, GAI-Tronics had a total of 420 employees, of which 174 employees were professional and technical personnel. In comparison, GAI-Tronics had a total of 392 employees on January 1, 1993, of which 169 were professional and technical personnel. MISCELLANEOUS The registrant expects no material effect on the capital expenditures, earnings and competitive position of the registrant and its subsidiaries from its or their compliance with federal, state or local laws or regulations controlling the discharge of materials into the environment or otherwise relating to the protection of the environment, although it does expect its engineering and consulting subsidiaries to undertake engineering work for many of their clients to support them in complying with such provisions. A portion of the revenue of the Gilbert companies is derived from customers or projects located outside the United States. All foreign revenues were from work authorizations with customers unaffiliated with the Gilbert companies. Certain services rendered to foreign clients have been undertaken in association with financing supplied or guaranteed by the U.S. Government or by U.S. or international banking institutions such as the U.S. Agency for International Development. Curtailment of such financing or guarantees could tend to reduce revenues from foreign sources. The countries providing the largest portion of foreign revenues in 1993 were the United Kingdom and Canada. The businesses of the registrant's subsidiaries are not seasonal to any material extent. ITEM 2.