-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, IbEpmrAFosJGH3Owk0Uvhil38SAD1cJEpwDQIhvBj4Q25pbxNAc5n1un65t6AJTW feTmjchQoGJu2PTxdtNZ/w== 0000950120-05-000591.txt : 20050809 0000950120-05-000591.hdr.sgml : 20050809 20050809162729 ACCESSION NUMBER: 0000950120-05-000591 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 9 CONFORMED PERIOD OF REPORT: 20050630 FILED AS OF DATE: 20050809 DATE AS OF CHANGE: 20050809 FILER: COMPANY DATA: COMPANY CONFORMED NAME: TUCSON ELECTRIC POWER CO CENTRAL INDEX KEY: 0000100122 STANDARD INDUSTRIAL CLASSIFICATION: ELECTRIC SERVICES [4911] IRS NUMBER: 860062700 STATE OF INCORPORATION: AZ FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 001-05924 FILM NUMBER: 051010250 BUSINESS ADDRESS: STREET 1: ONE SOUTH CHURCH AVENUE STREET 2: SUITE 100 CITY: TUCSON STATE: AZ ZIP: 85701 BUSINESS PHONE: 520-571-4000 MAIL ADDRESS: STREET 1: ONE SOUTH CHURCH AVENUE, SUITE 100 STREET 2: P.O. BOX 711 CITY: TUCSON STATE: AZ ZIP: 85702 FORMER COMPANY: FORMER CONFORMED NAME: TUCSON GAS & ELECTRIC CO /AZ/ DATE OF NAME CHANGE: 19790528 FILER: COMPANY DATA: COMPANY CONFORMED NAME: UNISOURCE ENERGY CORP CENTRAL INDEX KEY: 0000941138 STANDARD INDUSTRIAL CLASSIFICATION: ELECTRIC SERVICES [4911] IRS NUMBER: 860786732 STATE OF INCORPORATION: AZ FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 001-13739 FILM NUMBER: 051010251 BUSINESS ADDRESS: STREET 1: ONE SOUTH CHURCH AVENUE STREET 2: SUITE 100 CITY: TUCSON STATE: AZ ZIP: 85701 BUSINESS PHONE: 520-571-4000 MAIL ADDRESS: STREET 1: ONE SOUTH CHURCH AVENUE, SUITE 100 STREET 2: P.O. BOX 711 CITY: TUCSON STATE: AZ ZIP: 85702 10-Q 1 form10q.txt FORM 10-Q - JUNE 30, 2005 - -------------------------------------------------------------------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) [ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2005 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from __________ to _______. Commission Registrant; State of Incorporation; IRS Employer File Number Address; and Telephone Number Identification Number ----------- ----------------------------- --------------------- 1-13739 UNISOURCE ENERGY CORPORATION 86-0786732 (An Arizona Corporation) One South Church Avenue, Suite 100 Tucson, AZ 85701 (520) 571-4000 1-5924 TUCSON ELECTRIC POWER COMPANY 86-0062700 (An Arizona Corporation) One South Church Avenue, Suite 100 Tucson, AZ 85701 (520) 571-4000 Indicate by check mark whether each registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No ----- ----- Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). UniSource Energy Corporation Yes X No ----- ----- Tucson Electric Power Company Yes No X ----- ----- At August 4, 2005, 34,706,932 shares of UniSource Energy Corporation Common Stock, no par value (the only class of Common Stock), were outstanding. At August 4, 2005, 32,139,555 shares of Tucson Electric Power Company's common stock, no par value, were outstanding, of which 32,139,434 shares were held by UniSource Energy Corporation. - -------------------------------------------------------------------------------- This combined Form 10-Q is separately filed by UniSource Energy Corporation and Tucson Electric Power Company. Information contained in this document relating to Tucson Electric Power Company is filed by UniSource Energy Corporation and separately by Tucson Electric Power Company on its own behalf. Tucson Electric Power Company makes no representation as to information relating to UniSource Energy Corporation or its subsidiaries, except as it may relate to Tucson Electric Power Company. TABLE OF CONTENTS Definitions iv -- PART I -- Reports of Independent Registered Public Accounting Firm 1 Item 1. - Financial Statements 3 UniSource Energy Corporation Comparative Condensed Consolidated Statements of Income 3 Comparative Condensed Consolidated Statements of Cash Flows 4 Comparative Condensed Consolidated Balance Sheets 5 Condensed Consolidated Statement of Changes in Stockholders' Equity 6 Tucson Electric Power Company Comparative Condensed Consolidated Statements of Income 7 Comparative Condensed Consolidated Statements of Cash Flows 8 Comparative Condensed Consolidated Balance Sheets 9 Condensed Consolidated Statement of Changes in Stockholders' Equity 10 Notes to Condensed Consolidated Financial Statements 11 Note 1. Nature of Operations, Basis of Accounting Presentation and Equity-Based Compensation 11 Note 2. Regulatory Matters 13 Note 3. Debt and Credit Facilities 15 Note 4. Business Segments 17 Note 5. Accounting for Derivative Instruments and Trading Activities 18 Note 6. Commitments and Contingencies 21 Note 7. TEP Wholesale Accounts Receivable and Allowances 23 Note 8. UniSource Energy Earnings Per Share (EPS) 23 Note 9. Employee Benefits Plans 23 Note 10. Share-Based Compensation Plans 25 Note 11. Income and Other Taxes 26 Note 12. New Accounting Pronouncements 27 Note 13. Supplemental Cash Flow Information 28 Note 14. Subsequent Event 29 Note 15. Review by Independent Registered Public Accounting Firm 29 Item 2. - Management's Discussion and Analysis of Financial Condition and Results of Operations 30 UniSource Energy Consolidated 30 Results of Operations 31 Contribution by Business Segment 33 Liquidity and Capital Resources 33 Tucson Electric Power Company 37 Results of Operations 37 Factors Affecting Results of Operations 41 Liquidity and Capital Resources 45 UNS Gas 49 Results of Operations 49 Factors Affecting Results of Operations 51 Liquidity and Capital Resources 51 UNS Electric 53 Results of Operations 53 Factors Affecting Results of Operations 54 Liquidity and Capital Resources 55 Global Solar Energy, Inc. 56 Results of Operations 56 Other 56 Results of Operations 56 Critical Accounting Estimates 58 New Accounting Pronouncements 64 ii Safe Harbor for Forward-Looking Statements 65 Item 3. - Quantitative and Qualitative Disclosures about Market Risk 66 Item 4. - Controls and Procedures 68 PART II - OTHER INFORMATION Item 1. - Legal Proceedings 69 Item 4. - Submission of Matters to a Vote of Security Holders 70 Item 5. - Other Information 70 Non-GAAP Measures 70 Ratio of Earnings to Fixed Charges 73 SEC Reports Available on UniSource Energy's Website 73 Item 6. Exhibits 73 Signatures 74 Exhibit Index 75 iii DEFINITIONS The abbreviations and acronyms used in the 2005 Second Quarter 10-Q are defined below: - -------------------------------------------------------------------------------- 1941 Mortgage.................. TEP's Indenture, dated as of April 1, 1941, of TEP to JPMorgan Chase Bank, successor trustee, as supplemented and amended, which was satisfied and discharged on June 10, 2005. 1992 Mortgage.................. TEP's Indenture of Mortgage and Deed of Trust, dated as of December 1, 1992, of TEP to The Bank of New York, successor trustee, as supplemented. ACC............................ Arizona Corporation Commission. ACC Holding Company Order...... The order approved by the ACC in November 1997 allowing TEP to form a holding company. AHMSA.......................... Altos Hornos de Mexico, S.A. de C.V. AHMSA owns 50% of Sabinas. AMT............................ Alternative Minimum Tax. APS............................ Arizona Public Service Company. Btu............................ British thermal unit(s). Capacity....................... The ability to produce power; the most power a unit can produce or the maximum that can be taken under a contract; measured in MWs. CISO........................... California Independent System Operator. Citizens....................... Citizens Communications Company. Collateral Trust Bonds......... Bonds issued under the Indenture of Trust, dated as of August 1, 1998, of TEP to The Bank of New York, successor trustee. Common Stock................... UniSource Energy's common stock, without par value. Company or UniSource Energy.... UniSource Energy Corporation. Convertible Senior Notes....... UniSource Energy's 4.50% Convertible Senior Notes due March 1, 2035. Emissions Allowance(s)......... An allowance issued by the Environmental Protection Agency which permits emission of one ton of sulfur dioxide or one ton of nitrogen oxide. These allowances can be bought and sold. Energy......................... The amount of power produced over a given period of time; measured in MWh. ESP............................ Energy Service Provider. Express Line................... 345-kV circuit connecting Springerville Unit 2 to the Tucson 138-kV system. FAS 71......................... Statement of Financial Accounting Standards No. 71: Accounting for the Effects of Certain Types of Regulation. FAS 133........................ Statement of Financial Accounting Standards No. 133: Accounting for Derivative Instruments and Hedging Activities, as amended. FAS 143........................ Statement of Financial Accounting Standards No. 143: Accounting for Asset Retirement Obligations. FERC........................... Federal Energy Regulatory Commission. Four Corners................... Four Corners Generating Station. Global Solar................... Global Solar Energy, Inc., a company that develops and manufactures thin-film photovoltaic cells. Millennium owns 99% of Global Solar. Haddington..................... Haddington Energy Partners II, LP, a limited partnership that funds energy-related investments. Heating Degree Days............ An index used to measure the impact of weather on energy usage calculated by subtracting the average of the high and low daily temperatures from 65. IDBs........................... Industrial development revenue or pollution control revenue bonds. IPS............................ Infinite Power Solutions, Inc., a company that develops thin-film batteries. IRS............................ Internal Revenue Service. ISO............................ Independent System Operator. ITC............................ Investment Tax Credit. kWh............................ Kilowatt-hour(s). kV............................. Kilovolt(s). LIBOR.......................... London Interbank Offered Rate. LOC............................ Letter of Credit. iv Luna........................... Luna Energy Facility. MEG............................ Millennium Environmental Group, Inc., a wholly-owned subsidiary of Millennium, which manages and trades emissions allowances, coal, and related financial instruments. MicroSat....................... MicroSat Systems, Inc. is a company formed to develop and commercialize small-scale satellites. Millennium currently owns 35%. Millennium..................... Millennium Energy Holdings, Inc., a wholly-owned subsidiary of UniSource Energy. Mimosa......................... Minerales de Monclova, S.A. de C.V., an owner of coal and associated gas reserves and a supplier of metallurgical coal to the steel industry and thermal coal to the Mexican electricity commission. Sabinas owns 19.5% of Mimosa. MMBtus......................... Million British Thermal Units. MW............................. Megawatt(s). MWh............................ Megawatt-hour(s). Navajo......................... Navajo Generating Station. NOL............................ Net Operating Loss carryback or carryforward for income tax purposes. PGA............................ Purchased Gas Adjustor, a retail rate mechanism designed to recover the cost of gas purchased for retail gas customers. PNM............................ Public Service Company of New Mexico, a subsidiary of PNMR. PNMR........................... PNM Resources, Inc. Powertrusion................... POWERTRUSION International, Inc., a company owned 77% by Millennium, which manufactures lightweight utility poles. PPFAC.......................... Purchased Power and Fuel Adjustment Clause. PWCC........................... Pinnacle West Capital Corporation. Repurchased Bonds.............. $221 million of fixed-rate tax-exempt bonds that TEP purchased from bondholders on May 11, 2005. RTO............................ Regional Transmission Organization. Rules.......................... Retail Electric Competition Rules. Sabinas........................ Carboelectrica Sabinas, S. de R.L. de C.V., a Mexican limited liability company. Millennium owns 50% of Sabinas. Saguaro Utility................ An Arizona limited partnership, whose general partner was Sage Mountain, L.L.C. and whose limited partners included investment funds affiliated with Kohlberg Kravis Roberts & Co., L.P., J.P. Morgan Partners, L.L.C. and Wachovia Capital Partners. San Carlos..................... San Carlos Resources Inc., a wholly-owned subsidiary of TEP. San Juan....................... San Juan Generating Station. Sempra......................... Sempra Energy Trading Company. SCE Exchange................... A power exchange agreement between TEP and Southern California Edison Company (SCE). SES............................ Southwest Energy Solutions, Inc., a wholly-owned subsidiary of Millennium. Settlement Agreement........... TEP's Settlement Agreement approved by the ACC in November 1999 that provided for electric retail competition and transition asset recovery. Springerville.................. Springerville Generating Station. Springerville Coal Handling Facilities Leases........... Leveraged lease arrangements relating to the coal handling facilities serving Springerville. Springerville Common Facilities.................. Facilities at Springerville used in common with Springerville Unit 1 and Springerville Unit 2. Springerville Common Facilities Leases........... Leveraged lease arrangements relating to an undivided one-half interest in certain Springerville Common Facilities. Springerville Unit 1........... Unit 1 of the Springerville Generating Station. Springerville Unit 1 Lease..... Leveraged lease arrangement relating to Springerville Unit 1 and an undivided one-half interest in certain Springerville Common Facilities. Springerville Unit 2........... Unit 2 of the Springerville Generating Station. SRP............................ Salt River Project Agricultural Improvement and Power District. Sundt.......................... H. Wilson Sundt Generating Station (formerly known as the Irvington Generating Station). v Sundt Lease.................... The leveraged lease arrangement relating to Sundt Unit 4. SWG............................ Southwest Gas Corporation. TEP............................ Tucson Electric Power Company, the principal subsidiary of UniSource Energy. TEP Credit Agreement........... Credit Agreement between TEP and a syndicate of banks, dated as of May 4, 2005. TEP Revolving Credit Facility.. $60 million revolving credit facility entered into under the TEP Credit Agreement, dated as of May 4, 2005, between a syndicate of banks and TEP. Therm.......................... A unit of heating value equivalent to 100,000 British thermal units (Btu). Tri-State...................... Tri-State Generation and Transmission Association. TruePricing.................... TruePricing, Inc., a start-up company established to market energy related products. UED............................ UniSource Energy Development Company, a wholly-owned subsidiary of UniSource Energy, which engages in developing generation resources and other project development services and related activities. UES............................ UniSource Energy Services, Inc., an intermediate holding company established to own the operating companies (UNS Gas and UNS Electric) which acquired the Citizens Arizona gas and electric utility assets. UES is wholly owned by UniSource Energy. UES Settlement Agreement....... An agreement with the ACC Staff dated April 1, 2003, addressing rate case and financing issues in the acquisition by UniSource Energy of Citizens' Arizona gas and electric assets. UniSource Credit Agreement..... Credit Agreement between UniSource Energy and a syndicate of banks, dated as of April 15, 2005. UniSource Energy............... UniSource Energy Corporation. UNS Electric................... UNS Electric, Inc., a wholly-owned subsidiary of UES, which acquired the Citizens Arizona electric utility assets. UNS Gas........................ UNS Gas, Inc., a wholly-owned subsidiary of UES, which acquired the Citizens Arizona gas utility assets. UNS Gas/UNS Electric Revolver.. A $40 million revolving credit facility entered into by UNS Gas and UNS Electric on April 15, 2005. Valencia....................... Valencia power plant owned by UNS Electric. WestConnect.................... The proposed for-profit RTO in which TEP is a participant. vi REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders of UniSource Energy Corporation: We have reviewed the accompanying condensed consolidated balance sheet of UniSource Energy Corporation and its subsidiaries (the Company) as of June 30, 2005, and the related condensed consolidated statements of income for each of the three-month and six-month periods ended June 30, 2005 and 2004 and the condensed consolidated statement of cash flows for the six-month periods ended June 30, 2005 and 2004 and the condensed consolidated statement of changes in stockholders' equity for the six-month period ended June 30, 2005. These interim financial statements are the responsibility of the Company's management. We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion. Based on our review, we are not aware of any material modifications that should be made to the accompanying condensed consolidated interim financial statements for them to be in conformity with accounting principles generally accepted in the United States of America. We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet as of December 31, 2004, and the related consolidated statements of income, of cash flows and of changes in stockholders' equity for the year then ended, management's assessment of the effectiveness of the Company's internal control over financial reporting as of December 31, 2004 and the effectiveness of the Company's internal control over financial reporting as of December 31, 2004; and in our report dated March 16, 2005, we expressed unqualified opinions thereon. The consolidated financial statements and management's assessment of the effectiveness of internal control over financial reporting referred to above are not presented herein. In our opinion, the information set forth in the accompanying consolidated balance sheet information as of June 30, 2005, is fairly stated in all material respects in relation to the consolidated balance sheet from which it has been derived. /s/ PricewaterhouseCoopers LLP - ------------------------------ PRICEWATERHOUSECOOPERS LLP Los Angeles, California August 8, 2005 1 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders of Tucson Electric Power Company: We have reviewed the accompanying condensed consolidated balance sheet of Tucson Electric Power Company (the Company) as of June 30, 2005, and the related condensed consolidated statements of income for each of the three-month and six-month periods ended June 30, 2005 and 2004 and the condensed consolidated statement of cash flows for the six-month periods ended June 30, 2005 and 2004 and the condensed consolidated statement of changes in stockholders' equity for the six-month period ended June 30, 2005. These interim financial statements are the responsibility of the Company's management. We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion. Based on our review, we are not aware of any material modifications that should be made to the accompanying condensed consolidated interim financial statements for them to be in conformity with accounting principles generally accepted in the United States of America. We previously audited in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet as of December 31, 2004, and the related consolidated statements of income, of cash flows, and of changes in stockholders' equity for the year then ended (not presented herein), and in our report dated March 16, 2005 we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying consolidated balance sheet information as of June 30, 2005, is fairly stated in all material respects in relation to the consolidated balance sheet from which it has been derived. /s/ PricewaterhouseCoopers LLP - ------------------------------ PRICEWATERHOUSECOOPERS LLP Los Angeles, California August 8, 2005 2 PART I - FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS - -------------------------------------------------------------------------------- UNISOURCE ENERGY CORPORATION COMPARATIVE CONDENSED CONSOLIDATED STATEMENTS OF INCOME
Three Months Ended Six Months Ended June 30, June 30, 2005 2004 2005 2004 (UNAUDITED) (UNAUDITED) - ---------------------------------------------------------------------------------------------------------------------- -Thousands of Dollars- - Thousands of Dollars - OPERATING REVENUES $ 231,785 $224,056 Electric Retail Sales $ 403,375 $ 398,419 37,871 42,189 Electric Wholesale Sales 77,051 83,889 26,058 20,212 Gas Revenue 72,607 69,013 4,878 3,624 Other Revenues 8,488 8,844 - ---------------------------------------------------------------------------------------------------------------------- 300,592 290,081 TOTAL OPERATING REVENUES 561,521 560,165 - ---------------------------------------------------------------------------------------------------------------------- OPERATING EXPENSES 55,863 55,340 Fuel 103,154 102,789 68,897 55,586 Purchased Energy 133,304 115,088 61,248 56,410 Other Operations and Maintenance 122,740 119,989 33,344 36,560 Depreciation and Amortization 68,168 71,696 14,136 12,003 Amortization of Transition Recovery Asset 23,623 20,600 12,510 12,611 Taxes Other Than Income Taxes 26,009 25,722 - ---------------------------------------------------------------------------------------------------------------------- 245,998 228,510 TOTAL OPERATING EXPENSES 476,998 455,884 - ---------------------------------------------------------------------------------------------------------------------- 54,594 61,571 OPERATING INCOME 84,523 104,281 - ---------------------------------------------------------------------------------------------------------------------- OTHER INCOME (DEDUCTIONS) 5,076 5,013 Interest Income 10,037 9,882 1,649 1,338 Other Income 2,803 7,941 (998) (3,698) Other Expense (2,242) (2,602) - ---------------------------------------------------------------------------------------------------------------------- 5,727 2,653 TOTAL OTHER INCOME (DEDUCTIONS) 10,598 15,221 - ---------------------------------------------------------------------------------------------------------------------- INTEREST EXPENSE 19,744 20,032 Long-Term Debt 40,096 41,515 19,401 20,065 Interest on Capital Leases 39,147 40,109 5,427 - Loss on Reacquired Debt 5,427 1,635 (897) (329) Other Interest Expense, Net of Amounts Capitalized (886) (543) - ---------------------------------------------------------------------------------------------------------------------- 43,675 39,768 TOTAL INTEREST EXPENSE 83,784 82,716 - ---------------------------------------------------------------------------------------------------------------------- 16,646 24,456 INCOME BEFORE INCOME TAXES 11,337 36,786 7,178 11,655 Income Tax Expense 5,652 17,564 - ---------------------------------------------------------------------------------------------------------------------- $ 9,468 $ 12,801 NET INCOME $ 5,685 $ 19,222 ====================================================================================================================== 34,807 34,392 WEIGHTED-AVERAGE SHARES OF COMMON STOCK OUTSTANDING (000) 34,721 34,288 ====================================================================================================================== $0.27 $0.37 BASIC EARNINGS PER SHARE $0.16 $0.56 ====================================================================================================================== $0.27 $0.37 DILUTED EARNINGS PER SHARE $0.16 $0.55 ====================================================================================================================== $0.19 $0.16 DIVIDENDS PAID PER SHARE $0.38 $0.32 ======================================================================================================================
See Notes to Condensed Consolidated Financial Statements. 3 UNISOURCE ENERGY CORPORATION COMPARATIVE CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
Six Months Ended June 30, 2005 2004 (UNAUDITED) - ----------------------------------------------------------------------------------------------------- - Thousands of Dollars - CASH FLOWS FROM OPERATING ACTIVITIES Cash Receipts from Electric Retail Sales $ 417,057 $ 409,934 Cash Receipts from Electric Wholesale Sales 104,229 108,665 Cash Receipts from Gas Sales 95,382 90,056 MEG Cash Receipts from Trading Activity 61,640 73,405 Interest Received 11,239 11,042 Income Tax Refunds Received 1,484 286 Performance Deposits 7,193 1,456 Deposit - Second Mortgage Indenture - 17,040 Other Cash Receipts 5,401 9,585 Fuel Costs Paid (99,108) (92,935) Purchased Energy Costs Paid (160,582) (132,762) Wages Paid, Net of Amounts Capitalized (52,908) (48,973) Payment of Other Operations and Maintenance Costs (78,961) (69,215) MEG Cash Payments for Trading Activity (63,943) (73,096) Capital Lease Interest Paid (39,744) (41,576) Taxes Paid, Net of Amounts Capitalized (69,929) (70,589) Interest Paid, Net of Amounts Capitalized (39,132) (38,821) Income Taxes Paid (5,689) (8,152) Other Cash Payments (2,309) (4,114) - ----------------------------------------------------------------------------------------------------- NET CASH FLOWS - OPERATING ACTIVITIES 91,320 141,236 - ----------------------------------------------------------------------------------------------------- CASH FLOWS FROM INVESTING ACTIVITIES Capital Expenditures (90,067) (70,588) Proceeds from Investment in Springerville Lease Debt and Equity 8,251 8,054 Return of Investment from Millennium Energy Business 299 9,714 Other Cash Receipts 8,094 515 Payments for Investment in Springerville Lease Debt and Equity - (4,499) Investment in and Loans to Equity Investees (1,150) (424) - ----------------------------------------------------------------------------------------------------- NET CASH FLOWS - INVESTING ACTIVITIES (74,573) (57,228) - ----------------------------------------------------------------------------------------------------- CASH FLOWS FROM FINANCING ACTIVITIES Proceeds from Issuance of Long-Term Debt 240,000 - Repayments of Long-Term Debt (283,016) (1,232) Payments on Capital Lease Obligations (48,600) (43,641) Proceeds from Borrowings under Revolving Credit Facility 40,000 20,000 Payments on Borrowings under Revolving Credit Facility - (20,000) Proceeds from Stock Options Exercised 7,104 6,261 Other Cash Receipts 5,452 4,629 Payment of Debt Issue/Retirement Costs (10,621) (9,190) Common Stock Dividends Paid (14,823) (10,909) Other Cash Payments (3,032) (1,927) - ----------------------------------------------------------------------------------------------------- NET CASH FLOWS - FINANCING ACTIVITIES (67,536) (56,009) - ----------------------------------------------------------------------------------------------------- Net (Decrease) Increase in Cash and Cash Equivalents (50,789) 27,999 Cash and Cash Equivalents, Beginning of Year 154,028 101,266 - ----------------------------------------------------------------------------------------------------- CASH AND CASH EQUIVALENTS, END OF PERIOD $ 103,239 $ 129,265 =====================================================================================================
See Note 13 for supplemental cash flow information. See Notes to Condensed Consolidated Financial Statements. 4 UNISOURCE ENERGY CORPORATION COMPARATIVE CONDENSED CONSOLIDATED BALANCE SHEETS
June 30, December 31, 2005 2004 (UNAUDITED) - ------------------------------------------------------------------------------------------------- - Thousands of Dollars - ASSETS UTILITY PLANT Plant in Service $ 3,098,523 $ 3,033,405 Utility Plant under Capital Leases 723,901 723,901 Construction Work in Progress 140,058 116,161 - ------------------------------------------------------------------------------------------------- TOTAL UTILITY PLANT 3,962,482 3,873,467 Less Accumulated Depreciation and Amortization (1,396,432) (1,348,017) Less Accumulated Amortization of Capital Lease Assets (458,335) (444,313) - ------------------------------------------------------------------------------------------------- TOTAL UTILITY PLANT - NET 2,107,715 2,081,137 - ------------------------------------------------------------------------------------------------- INVESTMENTS AND OTHER PROPERTY Investments in Lease Debt and Equity 162,169 170,893 Other 81,969 85,035 - ------------------------------------------------------------------------------------------------- TOTAL INVESTMENTS AND OTHER PROPERTY 244,138 255,928 - ------------------------------------------------------------------------------------------------- CURRENT ASSETS Cash and Cash Equivalents 103,239 154,028 Trade Accounts Receivable 102,878 107,694 Unbilled Accounts Receivable 54,472 55,350 Allowance for Doubtful Accounts (16,724) (16,492) Materials and Fuel Inventory 68,482 62,225 Trading Assets 15,717 70,958 Current Regulatory Assets 10,006 9,653 Deferred Income Taxes - Current 21,478 24,055 Interest Receivable - Current 10,209 10,475 Other 17,047 26,751 - ------------------------------------------------------------------------------------------------- TOTAL CURRENT ASSETS 386,804 504,697 - ------------------------------------------------------------------------------------------------- REGULATORY AND OTHER ASSETS Transition Recovery Asset 200,405 224,029 Income Taxes Recoverable Through Future Revenues 42,280 44,624 Other Regulatory Assets 22,816 15,823 Other Assets 54,656 49,280 - ------------------------------------------------------------------------------------------------- TOTAL REGULATORY AND OTHER ASSETS 320,157 333,756 - ------------------------------------------------------------------------------------------------- TOTAL ASSETS $ 3,058,814 $ 3,175,518 ================================================================================================= CAPITALIZATION AND OTHER LIABILITIES CAPITALIZATION Common Stock Equity $ 583,886 $ 580,718 Capital Lease Obligations 660,437 701,931 Long-Term Debt 1,214,920 1,257,595 - ------------------------------------------------------------------------------------------------- TOTAL CAPITALIZATION 2,459,243 2,540,244 - ------------------------------------------------------------------------------------------------- CURRENT LIABILITIES Current Obligations under Capital Leases 56,136 53,694 Current Maturities of Long-Term Debt 5,000 1,725 Borrowings Under Revolving Credit Facility 40,000 - Accounts Payable 67,021 95,276 Interest Accrued 47,612 60,679 Trading Liabilities 14,902 65,022 Taxes Accrued 35,101 53,192 Accrued Employee Expenses 15,061 19,216 Customer Deposits 14,947 14,794 Other 6,611 4,556 - ------------------------------------------------------------------------------------------------- TOTAL CURRENT LIABILITIES 302,391 368,154 - ------------------------------------------------------------------------------------------------- DEFERRED CREDITS AND OTHER LIABILITIES Deferred Income Taxes - Noncurrent 117,347 101,753 Regulatory Liability - Net Cost of Removal for Interim Retirements 75,398 69,585 Other 104,435 95,782 - ------------------------------------------------------------------------------------------------- TOTAL DEFERRED CREDITS AND OTHER LIABILITIES 297,180 267,120 - ------------------------------------------------------------------------------------------------- COMMITMENTS AND CONTINGENCIES (NOTE 6) - ------------------------------------------------------------------------------------------------- TOTAL CAPITALIZATION AND OTHER LIABILITIES $ 3,058,814 $ 3,175,518 =================================================================================================
See Notes to Condensed Consolidated Financial Statements. 5 UNISOURCE ENERGY CORPORATION CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
Accumulated Common Accumulated Other Total Shares Common Earnings Comprehensive Stockholders' Outstanding* Stock (Deficit) Income (Loss) Equity - ------------------------------------------------------------------------------------------------------------------------------------ (UNAUDITED) - In Thousands - BALANCES AT DECEMBER 31, 2004 34,255 $ 677,119 $ (85,666) $ (10,735) $ 580,718 - ------------------------------------------------------------------------------------------------------------------------------------ Comprehensive Income: 2005 Year-to-Date Net Income - - 5,685 - 5,685 Unrealized Gain on Cash Flow Hedges (net of $2,078 income tax expense) - - - 3,170 3,170 Reclassification of Realized Gain on Cash Flow Hedges to Net Income (net of $363 income tax expense) - - - (554) (554) -------------- Total Comprehensive Income 8,301 -------------- Dividends Declared - (13,116) - (13,116) Shares Issued under Stock Compensation Plans 37 - - - - Shares Distributed by Deferred Compensation Trust - 1 - - 1 Shares Issued for Stock Options 367 7,779 - - 7,779 Other - 203 - - 203 - ------------------------------------------------------------------------------------------------------------------------------------ BALANCES AT JUNE 30, 2005 34,659 $ 685,102 $ (93,097) $ (8,119) $ 583,886 ==================================================================================================================================== * UniSource Energy has 75 million authorized shares of common stock.
See Notes to Condensed Consolidated Financial Statements. 6 TUCSON ELECTRIC POWER COMPANY COMPARATIVE CONDENSED CONSOLIDATED STATEMENTS OF INCOME
Three Months Ended Six Months Ended June 30, June 30, 2005 2004 2005 2004 (UNAUDITED) (UNAUDITED) - ------------------------------------------------------------------------------------------------------------------------- - Thousands of Dollars - - Thousands of Dollars - OPERATING REVENUES $195,470 $188,908 Electric Retail Sales $ 335,676 $ 332,084 37,802 42,121 Electric Wholesale Sales 76,930 83,770 3,607 2,713 Other Revenues 6,179 4,862 - ----------------------------------------------------------------------------------------------------------------------- 236,879 233,742 TOTAL OPERATING REVENUES 418,785 420,716 - ----------------------------------------------------------------------------------------------------------------------- OPERATING EXPENSES 55,863 55,340 Fuel 103,154 102,789 27,190 19,087 Purchased Power 40,051 25,339 47,213 42,576 Other Operations and Maintenance 95,190 90,405 27,934 32,025 Depreciation and Amortization 57,954 62,438 14,136 12,003 Amortization of Transition Recovery Asset 23,623 20,600 10,418 10,442 Taxes Other Than Income Taxes 21,567 21,188 - ----------------------------------------------------------------------------------------------------------------------- 182,754 171,473 TOTAL OPERATING EXPENSES 341,539 322,759 - ----------------------------------------------------------------------------------------------------------------------- 54,125 62,269 OPERATING INCOME 77,246 97,957 - ----------------------------------------------------------------------------------------------------------------------- OTHER INCOME (DEDUCTIONS) 4,903 5,000 Interest Income 9,719 9,861 - 2,319 Interest Income - Note Receivable from UniSource Energy 1,684 4,639 1,142 623 Other Income 1,798 1,185 (676) (357) Other Expense (999) (691) - ----------------------------------------------------------------------------------------------------------------------- 5,369 7,585 TOTAL OTHER INCOME (DEDUCTIONS) 12,202 14,994 - ----------------------------------------------------------------------------------------------------------------------- INTEREST EXPENSE 14,458 17,257 Long-Term Debt 31,437 36,003 19,392 20,049 Interest on Capital Leases 39,129 40,086 5,427 - Loss on Reacquired Debt 5,427 1,635 (882) (310) Other Interest Expense, Net of Amounts Capitalized (792) (499) - ----------------------------------------------------------------------------------------------------------------------- 38,395 36,996 TOTAL INTEREST EXPENSE 75,201 77,225 - ----------------------------------------------------------------------------------------------------------------------- 21,099 32,858 INCOME BEFORE INCOME TAXES 14,247 35,726 8,951 14,841 Income Tax Expense 6,789 16,915 - ----------------------------------------------------------------------------------------------------------------------- $ 12,148 $ 18,017 NET INCOME $ 7,458 $ 18,811 =======================================================================================================================
See Notes to Condensed Consolidated Financial Statements. 7 TUCSON ELECTRIC POWER COMPANY COMPARATIVE CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
Six Months Ended June 30, 2005 2004 (UNAUDITED) - ---------------------------------------------------------------------------------------------------------- - Thousands of Dollars - CASH FLOWS FROM OPERATING ACTIVITIES Cash Receipts from Electric Retail Sales $ 345,352 $ 340,603 Cash Receipts from Electric Wholesale Sales 104,165 108,528 Interest Received 21,919 10,568 Deposit - Second Mortgage Indenture - 17,040 Income Taxes Refunds Received 713 286 Other Cash Receipts 1,831 4,575 Fuel Costs Paid (99,108) (92,935) Purchased Power Costs Paid (59,609) (43,047) Wages Paid, Net of Amounts Capitalized (41,486) (36,799) Payment of Other Operations and Maintenance Costs (66,325) (53,443) Capital Lease Interest Paid (39,726) (41,572) Taxes Paid, Net of Amounts Capitalized (50,148) (48,618) Interest Paid, Net of Amounts Capitalized (33,948) (33,611) Income Taxes Paid (8,000) (10,002) Other Cash Payments (1,797) (2,980) - ---------------------------------------------------------------------------------------------------------- NET CASH FLOWS - OPERATING ACTIVITIES 73,833 118,593 - ---------------------------------------------------------------------------------------------------------- CASH FLOWS FROM INVESTING ACTIVITIES Capital Expenditures (67,523) (52,676) Proceeds from Investment in Springerville Lease Debt and Equity 8,251 8,054 Payments for Investment in Springerville Lease Debt and Equity - (4,499) Other Cash Receipts 6,708 - - ---------------------------------------------------------------------------------------------------------- NET CASH FLOWS - INVESTING ACTIVITIES (52,564) (49,121) - ---------------------------------------------------------------------------------------------------------- CASH FLOWS FROM FINANCING ACTIVITIES Equity Investment from UniSource Energy 110,000 - Proceeds from Repayment of UniSource Energy Note 95,393 - Repayments of Long-Term Debt (281,766) (1,225) Payments on Capital Lease Obligations (48,560) (43,599) Proceeds from Borrowings under Revolving Credit Facility 40,000 20,000 Payments on Borrowings under Revolving Credit Facility - (20,000) Other Cash Receipts 9,289 8,417 Payment of Debt Issue/Retirement Costs (5,203) (8,814) Dividends Paid to UniSource Energy - (7,000) Other Cash Payments (7,284) (1,079) - ---------------------------------------------------------------------------------------------------------- NET CASH FLOWS - FINANCING ACTIVITIES (88,131) (53,300) - ---------------------------------------------------------------------------------------------------------- Net (Decrease) Increase in Cash and Cash Equivalents (66,862) 16,172 Cash and Cash Equivalents, Beginning of Year 113,207 65,262 - ---------------------------------------------------------------------------------------------------------- CASH AND CASH EQUIVALENTS, END OF PERIOD $ 46,345 $ 81,434 ==========================================================================================================
See Note 13 for supplemental cash flow information. See Notes to Condensed Consolidated Financial Statements. 8 TUCSON ELECTRIC POWER COMPANY COMPARATIVE CONDENSED CONSOLIDATED BALANCE SHEETS
June 30, December 31, 2005 2004 (UNAUDITED) - --------------------------------------------------------------------------------------------------- - Thousands of Dollars - ASSETS UTILITY PLANT Plant in Service $ 2,810,585 $ 2,771,665 Utility Plant under Capital Leases 723,195 723,195 Construction Work in Progress 123,968 94,336 - --------------------------------------------------------------------------------------------------- TOTAL UTILITY PLANT 3,657,748 3,589,196 Less Accumulated Depreciation and Amortization (1,370,468) (1,328,228) Less Accumulated Amortization of Capital Lease Assets (458,162) (444,186) - --------------------------------------------------------------------------------------------------- TOTAL UTILITY PLANT - NET 1,829,118 1,816,782 - --------------------------------------------------------------------------------------------------- INVESTMENTS AND OTHER PROPERTY Investments in Lease Debt and Equity 162,169 170,893 Other 24,145 23,393 - --------------------------------------------------------------------------------------------------- TOTAL INVESTMENTS AND OTHER PROPERTY 186,314 194,286 - --------------------------------------------------------------------------------------------------- NOTE RECEIVABLE FROM UNISOURCE ENERGY - 79,462 - --------------------------------------------------------------------------------------------------- CURRENT ASSETS Cash and Cash Equivalents 46,345 113,207 Trade Accounts Receivable 82,555 72,042 Unbilled Accounts Receivable 41,740 33,179 Allowance for Doubtful Accounts (14,452) (14,166) Intercompany Accounts Receivable 6,186 10,111 Materials and Fuel Inventory 55,275 51,207 Current Regulatory Assets 10,006 9,653 Income Taxes Receivable 1,227 - Deferred Income Taxes - Current 20,821 24,157 Interest Receivable - Current 10,192 10,475 Other 13,823 18,330 - --------------------------------------------------------------------------------------------------- TOTAL CURRENT ASSETS 273,718 328,195 - --------------------------------------------------------------------------------------------------- REGULATORY AND OTHER ASSETS Transition Recovery Asset 200,405 224,029 Income Taxes Recoverable Through Future Revenues 42,280 44,624 Other Regulatory Assets 20,455 13,684 Other Assets 39,821 41,106 - --------------------------------------------------------------------------------------------------- TOTAL REGULATORY AND OTHER ASSETS 302,961 323,443 - --------------------------------------------------------------------------------------------------- TOTAL ASSETS $ 2,592,111 $ 2,742,168 =================================================================================================== CAPITALIZATION AND OTHER LIABILITIES CAPITALIZATION Common Stock Equity $ 562,235 $ 414,510 Capital Lease Obligations 659,955 701,405 Long-Term Debt 821,170 1,097,595 - --------------------------------------------------------------------------------------------------- TOTAL CAPITALIZATION 2,043,360 2,213,510 - --------------------------------------------------------------------------------------------------- CURRENT LIABILITIES Current Obligations under Capital Leases 56,051 53,611 Current Maturities of Long-Term Debt - 1,725 Borrowings Under Revolving Credit Facility 40,000 - Accounts Payable 43,241 46,377 Intercompany Accounts Payable 10,839 20,026 Interest Accrued 40,545 56,514 Taxes Accrued 29,329 44,938 Accrued Employee Expenses 13,082 17,594 Other 11,844 9,592 - --------------------------------------------------------------------------------------------------- TOTAL CURRENT LIABILITIES 244,931 250,377 - --------------------------------------------------------------------------------------------------- DEFERRED CREDITS AND OTHER LIABILITIES Deferred Income Taxes - Noncurrent 144,421 129,842 Regulatory Liability - Net Cost of Removal for Interim Retirements 72,513 67,485 Other 86,886 80,954 - --------------------------------------------------------------------------------------------------- TOTAL DEFERRED CREDITS AND OTHER LIABILITIES 303,820 278,281 - --------------------------------------------------------------------------------------------------- COMMITMENTS AND CONTINGENCIES (NOTE 6) - --------------------------------------------------------------------------------------------------- TOTAL CAPITALIZATION AND OTHER LIABILITIES $ 2,592,111 $ 2,742,168 ===================================================================================================
See Notes to Condensed Consolidated Financial Statements. 9 TUCSON ELECTRIC POWER COMPANY CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
Accumulated Capital Accumulated Other Total Common Stock Earnings Comprehensive Stockholders' Stock Expense (Deficit) Income (Loss) Equity - ------------------------------------------------------------------------------------------------------------------------------- (UNAUDITED) - Thousands of Dollars - BALANCES AT DECEMBER 31, 2004 $ 658,254 $ (6,357) $ (226,652) $ (10,735) $ 414,510 - ------------------------------------------------------------------------------------------------------------------------------- Comprehensive Income: 2005 Year-to-Date Net Income - - 7,458 - 7,458 Unrealized Gain on Cash Flow Hedges (net of $2,078 income tax expense) - - - 3,170 3,170 Reclassification of Realized Gain on Cash Flow Hedges to Net Income (net of $363 income tax expense) - - - (554) (554) ------------- Total Comprehensive Income 10,074 ------------- Equity Contribution from UniSource Energy 25,261 - - - 25,261 Capital Contribution from UniSource Energy 112,390 - - - 112,390 - ------------------------------------------------------------------------------------------------------------------------------- BALANCES AT JUNE 30, 2005 $ 795,905 $ (6,357) $ (219,194) $ (8,119) $ 562,235 ===============================================================================================================================
See Notes to Condensed Consolidated Financial Statements. 10 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - -------------------------------------------------------------------------------- NOTE 1. NATURE OF OPERATIONS, BASIS OF ACCOUNTING PRESENTATION AND EQUITY-BASED COMPENSATION UniSource Energy Corporation (UniSource Energy) is an exempt holding company under the Public Utility Holding Company Act of 1935. UniSource Energy has no significant operations of its own, but owns substantially all of the common stock of Tucson Electric Power Company (TEP) and all of the common stock of UniSource Energy Services, Inc. (UES), Millennium Energy Holdings, Inc. (Millennium) and UniSource Energy Development Company (UED). TEP, a regulated public utility incorporated in Arizona since 1963, is UniSource Energy's largest operating subsidiary and represented approximately 85% of UniSource Energy's assets as of June 30, 2005. TEP generates, transmits and distributes electricity. TEP serves approximately 380,000 retail electric customers in a 1,155 square mile area in Southern Arizona. TEP also sells electricity to other utilities and power marketing entities primarily located in the western U.S. UES holds the common stock of UNS Gas, Inc. (UNS Gas) and UNS Electric, Inc. (UNS Electric). UES has no significant operations of its own. UNS Gas is a gas distribution company serving approximately 135,900 retail customers in Mohave, Yavapai, Coconino, and Navajo Counties in northern Arizona, as well as Santa Cruz County in southeast Arizona. UNS Electric is an electric transmission and distribution company serving approximately 87,500 retail customers in Mohave and Santa Cruz counties. Millennium invests in unregulated businesses, including Global Solar Energy (Global Solar), a developer and manufacturer of thin-film photovoltaic cells and modules. UED engages in developing generating resources and other project development activities, including facilitating the expansion of the Springerville Generating Station, but has no significant operations. We conduct our business in four primary business segments - TEP's Electric Utility segment, UNS Gas, UNS Electric and Global Solar. References to "we" and "our" are to UniSource Energy and its subsidiaries, collectively. The accompanying quarterly financial statements of UniSource Energy and TEP are unaudited but reflect all normal recurring accruals and other adjustments which we believe are necessary for a fair presentation of the results for the interim periods presented. These financial statements are presented in accordance with the Securities and Exchange Commission's (SEC) interim reporting requirements which do not include all the disclosures required by accounting principles generally accepted in the United States of America (GAAP) for audited annual financial statements. The year-end condensed balance sheet data was derived from audited financial statements, but does not include disclosures required by GAAP for audited annual financial statements. This quarterly report should be reviewed in conjunction with UniSource Energy and TEP's 2004 Annual Report on Form 10-K. Weather, among other factors, causes seasonal fluctuations in TEP, UNS Gas and UNS Electric's sales; therefore, quarterly results are not indicative of annual operating results. UniSource Energy and TEP have made minor reclassifications to the prior year financial statements for comparative purposes. These reclassifications had no effect on net income. DEPRECIATION During the second quarter 2005, a study requested by the participants in the San Juan Generating Station (San Juan) was completed which indicated San Juan's economic useful life had changed from previous estimates. As a result of the study and other analysis performed, TEP lengthened the estimated useful life of San Juan from 40 to 60 years beginning April 1, 2005. TEP's depreciation expense for the three months ended June 30, 2005, decreased approximately $2 million. Annual depreciation expense is expected to decrease by $6 million or $3 million for the remainder of 2005. During the second quarter of 2005, it was determined that depreciation of certain UNS Gas and UNS Electric assets had been overstated in prior periods. An adjustment was recorded in June 2005 which reduced UNS' Other Operations and Maintenance Expense by $1 million. 11 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) - -------------------------------------------------------------------------------- EQUITY-BASED COMPENSATION UniSource Energy has two equity-based compensation plans, the 1994 Outside Director Stock Option Plan (Directors' Plan) and the 1994 Omnibus Stock and Incentive Plan (Omnibus Plan). See Note 10. We adopted Statement of Financial Accounting Standards No. 123(R), Share Based Payment (FAS 123(R)) effective January 1, 2005. The adoption of FAS 123(R) did not have a significant impact on our financial statements because stock options issued under UniSource Energy's Omnibus Plan vested upon the shareholder vote to approve the proposed acquisition of UniSource Energy, see UniSource Energy's 2004 Annual Report on Form 10-K, Note 17 in Notes to Consolidated Financial Statements - Stock-Based Compensation. After February 4, 2004, no new awards can be granted under the Omnibus Plan. Prior to January 1, 2005, we accounted for those plans under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees (APB 25), and related interpretations. All our stock options granted under the Omnibus Plan were granted with an exercise price equal to the market value of the stock at the date of the grant. Accordingly, under the provisions of APB 25, no compensation expense was recorded for these awards. However, compensation expense was recognized for restricted stock, stock unit and performance share awards over the performance/vesting period. The following table illustrates the effect on UniSource Energy's net income and earnings per share and TEP's net income as if we had applied the fair value recognition provisions of FAS 123(R) to all equity-based employee compensation awards for the three and six months ended June 30, 2004: UNISOURCE ENERGY: - ----------------
Three Months Ended Six Months Ended June 30, June 30, 2004 2004 - ------------------------------------------------------------- --------------------------- ------------------------ -Thousands of Dollars- (except per share data) Net Income - As Reported $ 12,801 $ 19,222 Add: Equity-based compensation expense included in reported net income, net of related tax effects 66 1,309 Deduct: Total equity-based employee compensation expense determined under fair value based method for all awards, net of related tax effects (74) (2,072) - ------------------------------------------------------------- --------------------------- ------------------------ Pro Forma Net Income $ 12,793 $ 18,459 ============================================================= =========================== ======================== Basic Earnings per Share: As Reported $0.37 $0.56 Pro Forma $0.37 $0.54 ============================================================= =========================== ======================== Diluted Earnings per Share: As Reported $0.37 $0.55 Pro Forma $0.36 $0.53 ============================================================= =========================== ========================
TEP: - ----
Three Months Ended Six Months Ended June 30, June 30, 2004 2004 - ------------------------------------------------------------- --------------------------- ------------------------ -Thousands of Dollars- Net Income - As Reported $ 18,017 $ 18,811 Add: Equity-based compensation expense included in reported net income, net of related tax effects 57 1,176 Deduct: Total equity-based employee compensation expense determined under fair value based method for all awards, net of related tax effects (64) (1,925) - ------------------------------------------------------------- --------------------------- ------------------------ Pro Forma Net Income $ 18,010 $ 18,062 ============================================================= =========================== ========================
12 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) - -------------------------------------------------------------------------------- The fair value of each stock option grant is estimated on the date of grant using the Black-Scholes option-pricing model. There were no stock options granted during the six months ended June 30, 2004. For the 21,222 options granted under the Directors' Plan in 2003, the following weighted average assumptions were used:
Expected life (years) 6 Interest rate 3.34% Volatility 23.74% Dividend yield 3.55% Weighted-average grant-date fair value of options granted during the period $3.16 -------------------------------------------------------------------
NOTE 2. REGULATORY MATTERS - -------------------------- REGULATORY ACCOUNTING TEP, UNS Gas and UNS Electric generally use the same accounting policies and practices used by unregulated companies for financial reporting under GAAP. However, sometimes these principles, such as Statement of Financial Accounting Standards No. 71, Accounting for the Effects of Certain Types of Regulation (FAS 71), require special accounting treatment for regulated companies to show the effect of regulation. For example, in setting TEP, UNS Gas and UNS Electric's retail rates, the Arizona Corporation Commission (ACC) may not allow TEP, UNS Gas or UNS Electric to currently charge their customers to recover certain expenses, but instead may require that these expenses be charged to customers in the future. In this situation, FAS 71 requires that TEP, UNS Gas and UNS Electric defer these items and show them as regulatory assets on the balance sheet until TEP, UNS Gas and UNS Electric are allowed to charge their customers. TEP, UNS Gas and UNS Electric then amortize these items as expense to the income statement as these charges are recovered from customers. Similarly, certain revenue items may be deferred as regulatory liabilities, which are also eventually amortized to the income statement as rates to customers are reduced. The conditions a regulated company must satisfy to apply the accounting policies and practices of FAS 71 include: o an independent regulator sets rates; o the regulator sets the rates to recover specific costs of delivering service; and o the service territory lacks competitive pressures to reduce rates below the rates set by the regulator. IMPLICATIONS OF DISCONTINUING APPLICATION OF FAS 71 TEP Upon approval by the ACC of a settlement agreement (Settlement Agreement) in November 1999, TEP discontinued application of FAS 71 for its generation operations. TEP continues to apply FAS 71 to its cost-based rate regulated operations, which include the transmission and distribution portions of its business. TEP's transmission and distribution regulatory assets, net of regulatory liabilities, totaled $201 million at June 30, 2005. Regulatory assets of $30 million are not presently included in rate base and consequently are not earning a return on investment. These regulatory assets are being recovered through the cost of service or are authorized to be collected in future base rates. TEP's transmission and distribution regulatory assets, net of regulatory liabilities, totaled $225 million at December 31, 2004. TEP regularly assesses whether it can continue to apply FAS 71 to its cost-based rate regulated operations. If TEP stopped applying FAS 71 to these operations, it would write off the related balances of its regulatory assets as an expense and its regulatory liabilities as income on its income statement. Based on the regulatory asset balances, net of regulatory liabilities, at June 30, 2005, if TEP had stopped applying FAS 71 to its remaining cost-based rate regulated operations, it would have recorded an extraordinary after-tax loss of $121 million. While regulatory orders and market conditions may affect cash flows, TEP's cash flows would not be affected if it stopped applying FAS 71 unless a regulatory order limited its ability to recover the cost of its regulatory assets. 13 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) - -------------------------------------------------------------------------------- UNS GAS AND UNS ELECTRIC UNS Gas and UNS Electric's regulatory liabilities exceed their regulatory assets by $6 million at June 30, 2005. At December 31, 2004, UNS Gas and UNS Electric' regulatory assets, net of regulatory liabilities, totaled $4 million. UNS Gas and UNS Electric's regulatory assets and liabilities are included in rates and consequently are earning a return. If UNS Gas and UNS Electric stopped applying FAS 71 to their regulated operations, they would write off the related balances of their regulatory assets as an expense and would write off their regulatory liabilities as income on their income statements. Based on the regulatory asset and liability balances, if UNS Gas and UNS Electric had stopped applying FAS 71 to their regulated operations, they would have recorded an extraordinary after-tax gain of $3 million at June 30, 2005. UNS Gas and UNS Electric's cash flows would not be affected if they stopped applying FAS 71 unless a regulatory order limited their ability to recover the cost of their regulatory assets. RECENT REGULATORY ACTION TEP Given recent court action, the ACC may revise its Rules and rate methodologies prior to the expiration in 2008 of the Settlement Agreement. A new structure could replace that established pursuant to the Settlement Agreement prior to January 2009. In an effort to resolve the uncertainty surrounding the methodology that will be applied to determine TEP's rates for generation service after the Competition Transition Charges (CTCs) expire, TEP filed a motion with the ACC on May 4, 2005 requesting that the ACC issue an order declaring its position regarding the rate treatment that will be afforded to TEP's generation assets after 2008. The motion states TEP's preference for the ACC to adhere to the Settlement Agreement and continue to authorize TEP to charge market-based rates for generation services after December 31, 2008. The motion also states that, if the ACC intends to rescind TEP's authorization to charge market-based rates for its generation services, that change will have immediate consequences for the Settlement Agreement, the 2004 general rate case information filing and future TEP rate cases. Accordingly, TEP requested that the ACC clarify its intentions in this regard. In addition, TEP requested that a procedural conference be held in the 2004 rate review proceedings to discuss the status of that case pending the issuance of an order in response to TEP's motion. In May 2005, a number of participants in TEP's rate proceedings, including the Staff of the ACC, filed responses to TEP's motion. Those responses reflect differing interpretations of the Settlement Agreement which established TEP's existing rate structure and generation service rates, and the effect of the 2002 Track A order which eliminated the requirement that TEP transfer its generation assets to a subsidiary and the future of electric competition in Arizona. A number of these responses dispute TEP's assertion that the existing rate structure contemplates market-based rates for generation services after December 31, 2008. On June 1, 2005, TEP filed a reply in support of its motion. The reply stated that the differences of opinion expressed in the various responses filed underscore the need for the ACC to clarify how it will determine TEP's rates for generation services after December 31, 2008. TEP's reply also stated that, although it would prefer that the ACC continue to authorize TEP to charge market-based rates for generation services after December 31, 2008, it is concerned that its customers will be subject to a significant rate increase in 2009. TEP believes that any actions by the ACC should not deny TEP the economic benefits of the Settlement Agreement, and accordingly analyzed how the Settlement Agreement can be modified so as to: (i) preserve the intent of the parties; (ii) avoid a significant rate increase in 2009; (iii) mitigate a negative financial impact on TEP; and (iv) provide all interested parties with certainty in the near future about TEP's post-2008 rate structure. TEP's reply suggests that these goals can be accomplished through a modification to the Settlement Agreement which includes the following concepts: (i) an extension of the existing rate freeze at current rates; (ii) retention of the current CTC amortization schedule; (iii) a commitment not to seek rate treatment for certain TEP generation assets; and (iv) implementation of a mechanism to protect TEP from extreme fuel market volatility after December 31, 2008. TEP intends to discuss its proposal with the parties to the Settlement Agreement and ACC staff and, thereafter, enter into formal negotiations to seek to modify the Settlement Agreement. 14 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) - -------------------------------------------------------------------------------- On June 10, 2005 and on July 11, 2005, the ALJ issued procedural orders related to TEP's 2004 rate review. The procedural orders took no action on TEP's May 4, 2005 motion, however suggested a more appropriate procedure was for TEP to file a motion to reopen the record approving the Settlement Agreement. On July 25, 2005, TEP informed the ALJ that it will file a motion by September 12, 2005, seeking to amend the decision approving the Settlement Agreement to address TEP's concerns about how rates will be set after December 31, 2008. UNS GAS In March 2005, the ACC approved a PGA surcharge of $0.03 per therm beginning April 11, 2005 and lasting until the excess gas purchase costs are fully recovered. Based on current and projected gas prices and the rates currently in effect, we expect the PGA balance to increase. Given these gas price projections and expected pipeline transportation cost increases, UNS Gas may be required to request an increase in this surcharge. The under recovered gas purchase costs of $2.1 million as of June 30, 2005, are recorded in Other Regulatory Assets on UniSource Energy's balance sheet. NOTE 3. DEBT AND CREDIT FACILITIES - ---------------------------------- Long-term debt matures more than one year from the date of the financial statements. UNISOURCE ENERGY DEBT CONVERTIBLE SENIOR NOTES In March 2005, UniSource Energy issued $150 million of 4.50% Convertible Senior Notes due 2035 in a private placement. The Convertible Senior Notes are unsecured and are not guaranteed by TEP or any other UniSource Energy subsidiary. Each $1,000 of Convertible Senior Notes is convertible into 26.6667 shares of our Common Stock at any time. This represents a conversion price of approximately $37.50 per share of our Common Stock, which is subject to adjustment in certain circumstances. On March 1, 2005, UniSource Energy used $106 million of the net proceeds from the sale of the Convertible Senior Notes to repay its $95 million promissory note to TEP plus accrued interest of $11 million. TEP used these funds, along with borrowings under its revolving credit facility to repurchase and redeem $225 million of fixed rate tax-exempt borrowings. See TEP Debt - Bond Repurchase and Redemptions, below. UNISOURCE CREDIT AGREEMENT On April 15, 2005, UniSource Energy entered into a $105 million five-year credit agreement with a group of lenders (UniSource Credit Agreement) which expires on April 15, 2010. The UniSource Credit Agreement includes a $90 million term loan facility and a $15 million revolving credit facility. Quarterly principal payments of $1.25 million are due beginning June 30, 2005, with the balance due at maturity. As of June 30, 2005, UniSource Energy borrowed $89 million under the term loan facility at an interest rate of 5.2%. As of June 30, 2005, there were no borrowings outstanding under the revolving credit facility. We pay interest on the term loan and on borrowings under the revolving credit facility at LIBOR plus 1.75% or the agent bank's reference rate plus 0.75%. If after June 30, 2005, TEP cannot pay 100% of its current year net income as dividends due to regulatory restrictions, interest rates would increase by 0.25%. We paid a commitment fee of 0.50% on the unused portion of the term loan until it was fully drawn at June 29, 2005, and pay a commitment fee of 0.50% on the unused portion of the revolving credit facility. The UniSource Credit Agreement restricts additional indebtedness, liens, mergers, sales of assets and investments and acquisitions. We must also meet: (1) a minimum cash flow to interest coverage ratio for UniSource Energy on a standalone basis and (2) a maximum leverage ratio on a consolidated basis. We may pay dividends, if after giving effect to the dividend payments, we have more than $15 million of unrestricted cash and unused revolving credit. As of June 30, 2005, we were in compliance with the terms of the UniSource Credit Agreement. 15 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) - -------------------------------------------------------------------------------- If an event of default occurs, the UniSource Credit Agreement may become immediately due and payable. An event of default includes failure to make required payments under the UniSource Credit Agreement, failure of UniSource Energy or certain subsidiaries to make payments or default on debt greater than $20 million, or certain bankruptcy events at UniSource Energy or certain subsidiaries. INTER-COMPANY NOTE AND CAPITAL CONTRIBUTION FROM UNISOURCE ENERGY In January 2005, UNS Gas established a short-term inter-company promissory note to UniSource Energy that allows UNS Gas to borrow up to $10 million for general corporate purposes. In May 2005, UniSource Energy made a $110 million capital contribution to TEP. TEP DEBT BOND REPURCHASE AND REDEMPTIONS TEP made a sinking fund payment of $1 million on its 6.1% 1941 Mortgage IDBs in January 2005. In March 2005, TEP redeemed at par the remaining $31 million of its 6.1% 1941 Mortgage IDBs, which were due in 2008, as well as the remaining $21 million of its 7.5% 1941 Mortgage IDBs, which were due in 2006. TEP recorded expense of $0.1 million for debt costs that were capitalized and being amortized through 2008. On June 10, 2005, TEP satisfied and discharged the 1941 Mortgage. In May 2005, TEP purchased $147 million of its 1997 Pima Series B and $74 million of its 1997 Pima Series C fixed-rate tax-exempt bonds (Repurchased Bonds) at a price of $101.50 per $100 principal amount and redeemed at par the remaining $4 million of bonds outstanding under those series. TEP does not currently plan on canceling the Repurchased Bonds which will remain outstanding under their respective indentures; however, the Repurchased Bonds will not be presented in our financial statements. TEP recognized a loss of approximately $3 million on the Repurchased Bonds associated with the generation portion of its business. In addition, TEP capitalized approximately $3 million of costs for Repurchased Bonds associated with its regulated operations and will amortize the cost over the remaining life of the bonds. TEP may choose to cancel or resell the Repurchased Bonds to third parties in the future. As a result of the capital contribution, inter-company note repayment and the bond purchases and redemptions, TEP's ratio of equity to total capitalization (excluding capital leases) improved to 40.6% as of June 30, 2005, which meets an ACC requirement and allows TEP to dividend up to 100% of its current year net income to UniSource Energy. Management believes it will be able to maintain a 40% ratio of equity to total capitalization (excluding capital leases) through the remainder of 2005. TEP CREDIT AGREEMENT In May 2005, TEP entered into a new $401 million Credit Agreement (TEP Credit Agreement) to replace its previous $401 million credit agreement. The TEP Credit Agreement includes a $60 million revolving credit facility and a $341 million letter of credit facility to support $329 million of tax-exempt variable rate bonds. The TEP Credit Agreement expires May 4, 2010 and is secured by $401 million of Mortgage Bonds. The TEP Credit Agreement restricts additional indebtedness, liens, sale of assets and sale-leasebacks agreements. The TEP Credit Agreement also requires TEP to meet a minimum cash coverage ratio and a maximum leverage ratio. If TEP complies with the terms of the TEP Credit Agreement, TEP may pay dividends to UniSource Energy. Certain regulatory actions may cause a decrease in the amount that may be borrowed. As of June 30, 2005, TEP was in compliance with the terms of the TEP Credit Agreement. If an event of default occurs, the TEP Credit Agreement may become immediately due and payable. An event of default includes failure to make required payments under the TEP Credit Agreement; change in control, as defined; failure of TEP or certain subsidiaries to make payments or default on debt greater than $20 million; or certain bankruptcy events at TEP or certain subsidiaries. Interest rates and fees under the TEP Credit Agreement are based on a pricing grid tied to TEP's credit ratings. Letter of credit fees are 0.875% per annum and amounts drawn under a letter of credit would bear interest at LIBOR 16 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) - -------------------------------------------------------------------------------- plus 0.875% per annum. TEP pays interest on borrowings under the revolving credit facility at LIBOR plus 0.875% or at the agent bank's reference rate. TEP also pays a commitment fee of 0.20% on the unused portion of the revolving credit facility. In May 2005, TEP expensed $3 million for debt costs related to the previous credit agreement that were capitalized and being amortized through 2009. Fees of $5 million associated with the TEP Credit Agreement are being amortized through May 2010. As of June 30, 2005, TEP had $40 million outstanding under the revolving credit facility component of the TEP Credit Agreement at an interest rate of 4.9%. TEP repaid $30 million of these amounts in July 2005. UNS GAS/UNS ELECTRIC REVOLVER In April 2005, UNS Gas and UNS Electric entered into a $40 million three-year unsecured revolving credit agreement due April 15, 2008 with a group of lenders (the UNS Gas/UNS Electric Revolver). Either borrower may borrow up to a maximum of $30 million; however, the total combined amount borrowed cannot exceed $40 million. UNS Gas is only liable for UNS Gas' borrowings, and similarly, UNS Electric is only liable for UNS Electric's borrowings under the UNS Gas/UNS Electric Revolver. UES guarantees the obligations of both UNS Gas and UNS Electric. The borrowers pay interest at LIBOR plus 1.50% or at the agent bank's reference rate plus 0.50%. UNS Gas and UNS Electric also pay a commitment fee of 0.45% on the unused portion of the revolving credit facility. The UNS Gas/UNS Electric Revolver contains restrictions on additional indebtedness, liens, mergers and sales of assets. The UNS Gas/UNS Electric Revolver also contains a maximum leverage ratio and a minimum cash flow to interest coverage ratio for each borrower. As of June 30, 2005, UNS Gas and UNS Electric were each in compliance with the terms of the UNS Gas/UNS Electric Revolver. If an event of default occurs, the UNS Gas/UNS Electric Revolver may become immediately due and payable. An event of default includes failure to make required payments under the UNS Gas/UNS Electric Revolver; certain change in control transactions, certain bankruptcy events of UNS Gas or UNS Electric, or failure of UES, UNS Gas or UNS Electric to make payments or default on debt greater than $4 million. As of June 30, 2005, UNS Gas and UNS Electric had no borrowings outstanding under the UNS Gas/UNS Electric Revolver. NOTE 4. BUSINESS SEGMENTS - -------------------------- Based on the way we organize our operations and evaluate performance, we have four reportable segments: (1) TEP, a vertically integrated electric utility business, is UniSource Energy's largest subsidiary. (2) UNS Gas is a regulated gas distribution utility business. (3) UNS Electric is a regulated electric distribution utility business. (4) Global Solar, a developer and manufacturer of light-weight thin-film photovoltaic cells and panels, is the largest investment held by Millennium. The UniSource Energy, UES and Millennium holding companies, UED, and several other subsidiaries and equity investments, which are not considered reportable segments, are included in All Other. Through affiliates, Millennium holds investments in several unregulated energy and emerging technology companies. UED, a wholly-owned subsidiary of UniSource Energy, developed generating resources and performed other project development activities, including the expansion of the Springerville Generating Station. Significant reconciling adjustments consist of the elimination of inter-company activity and balances. Other Millennium subsidiaries recorded revenue from transactions with TEP of $3 million and $6 million during the three-month and six-month periods ended June 30, 2005 and $6 million and $8 million during the three-month and six-month periods ended June 30, 2004. TEP's related expense is reported in Other Operations and Maintenance expense on its income statement. Millennium's revenue and TEP's related expense are eliminated in UniSource Energy consolidation. Other significant reconciling adjustments include the elimination of investments in subsidiaries held by UniSource Energy, the inter-company note between UniSource Energy and TEP, the related interest 17 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) - -------------------------------------------------------------------------------- income and expense on the note and reclassifications of deferred tax assets and liabilities. The inter-company note between UniSource Energy and TEP was repaid on March 1, 2005. See Note 3. We disclose selected financial data for our reportable segments in the following table:
REPORTABLE SEGMENTS ----------------------------------------- UNISOURCE UNS UNS GLOBAL ALL RECONCILING ENERGY TEP GAS ELECTRIC SOLAR OTHER ADJUSTMENTS CONSOLIDATED - --------------------------------------------- ---------- --------- ----------- -------- ------------ -------------- ---------------- INCOME STATEMENT -Millions of Dollars- - ---------------- THREE MONTHS ENDED JUNE 30, 2005: Operating Revenues - External $ 236 $ 27 $ 37 $ 1 $ - $ - $ 301 Operating Revenues - Intersegment 1 - - - 3 (4) - Income (Loss) Before Income Taxes 21 - 2 (3) (3) - 17 Net Income (Loss) 12 - 1 (2) (2) - 9 - --------------------------------------------- ---------- --------- ----------- -------- ------------ -------------- ---------------- - --------------------------------------------- ---------- --------- ----------- -------- ------------ -------------- ---------------- THREE MONTHS ENDED JUNE 30, 2004: Operating Revenues - External $ 234 $ 21 $ 35 $ - $ - $ - $ 290 Operating Revenues - Intersegment - - - 2 4 (6) - Income (Loss) Before Income Taxes 33 (2) 3 (2) (8) - 24 Net Income (Loss) 18 (1) 1 (1) (4) - 13 - --------------------------------------------- ---------- --------- ----------- -------- ------------ -------------- ---------------- - --------------------------------------------- ---------- --------- ----------- -------- ------------ -------------- ---------------- SIX MONTHS ENDED JUNE 30, 2005: Operating Revenues - External $ 418 $ 74 $ 68 $ 2 $ - $ - $ 562 Operating Revenues - Intersegment 1 - - - 6 (7) - Income (Loss) Before Income Taxes 14 7 2 (5) (7) - 11 Net Income (Loss) 7 4 1 (3) (3) - 6 - --------------------------------------------- ---------- --------- ----------- -------- ------------ -------------- ---------------- - --------------------------------------------- ---------- --------- ----------- -------- ------------ -------------- ---------------- SIX MONTHS ENDED JUNE 30, 2004: Operating Revenues - External $ 420 $ 70 $ 67 $ 1 $ 2 $ - $ 560 Operating Revenues - Intersegment 1 - - 2 6 (9) - Income (Loss) Before Income Taxes 36 6 3 (4) (4) - 37 Net Income (Loss) 19 3 2 (2) (3) - 19 - --------------------------------------------- --------- ---------- ---------- -------- ------------ --------------- -------------- - --------------------------------------------- --------- ---------- ---------- -------- ------------ --------------- -------------- BALANCE SHEET Total Assets, June 30, 2005 $ 2,592 $ 199 $ 145 $ 21 $ 950 $ (848) $ 3,059 Total Assets, December 31, 2004 2,742 201 135 21 930 (853) 3,176 - --------------------------------------------- --------- ---------- ---------- -------- ------------ --------------- --------------
NOTE 5. ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND TRADING ACTIVITIES - -------------------------------------------------------------------- TEP enters into forward contracts to purchase or sell a specified amount of capacity or energy at a specified price over a given period of time, typically for one month, three months, or one year, within established limits to take advantage of favorable market opportunities. In general, TEP enters into forward purchase contracts when market conditions provide the opportunity to purchase energy for its load at prices that are below the marginal cost of its supply resources or to supplement its own resources (e.g., during plant outages and summer peaking periods). TEP enters into forward sales contracts when it forecasts that it has excess supply and the market price of energy exceeds its marginal cost. The majority of TEP's forward contracts are considered to be normal purchases and sales and, therefore, are not required to be marked to market. However, some of the forward contracts are considered to be derivatives, which TEP marks to market by recording unrealized gains and losses and adjusting the related assets and liabilities on a monthly basis to reflect the market prices at the end of the month. TEP has a natural gas supply agreement under which it purchases all of its gas requirements at spot market prices from Southwest Gas Corporation (SWG). TEP also has agreements to purchase power that are priced using spot market gas prices. These contracts meet the definition of normal purchases and are not required to be marked to market. During 2004 and early 2005, in an effort to minimize price risk on these purchases, TEP entered into commodity price swap agreements under which TEP purchases gas at fixed prices and simultaneously sells gas at spot market prices. The spot market price in the swap agreements is tied to the same index as the purchases under the SWG and purchased power contracts. These swap agreements, which expire during the summer months through 18 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) - -------------------------------------------------------------------------------- 2007, were entered into with the goal of locking in fixed prices on at least 45% and not more than 80% of TEP's expected summer monthly gas risk prior to entering into the month. TEP's swap agreements are derivatives required to be marked to market on a monthly basis; however, since the agreements satisfy the requirements for cash flow hedge accounting, the unrealized gains and losses are recorded in Other Comprehensive Income, a component of Common Stock Equity, rather than being reflected in the income statement. As the gains and losses on these cash flow hedges are realized, a reclassification adjustment is recorded in Other Comprehensive Income for realized gains and losses that are included in Net Income. TEP manages the risk of counterparty default by performing financial credit reviews, setting limits, monitoring exposures, requiring collateral when needed, and using a standardized agreement which allows for the netting of current period exposures to and from a single counterparty. UNS Gas has a natural gas supply agreement under which it purchases substantially all of its gas requirements at market prices from BP Energy Company (BP). However, the contract allows UNS Gas to lock in fixed prices on a portion of its gas purchases by entering into fixed price forward contracts with BP at various times during the year. This enables UNS Gas to provide more stable prices to its customers. These purchases are made up to three years in advance with the goal of locking in fixed prices on at least 45% and not more than 80% of expected monthly gas consumption. These forward contracts, as well as the main gas supply contract, meet the definition of normal purchases and therefore are not required to be marked to market. UNS Electric does not currently have any contracts that are required to be marked to market. Millennium Environmental Group, Inc. (MEG), a wholly-owned subsidiary of Millennium, enters into swap agreements, options and forward contracts relating to Emissions Allowances and coal. MEG marks its trading contracts to market by recording unrealized gains and losses and adjusting the related assets and liabilities on a monthly basis to reflect the market prices at the end of the month. MEG is in the process of winding down its activities and will not engage in any new activities after 2005. The market prices used to determine fair values for TEP and MEG's derivative instruments are estimated based on various factors including broker quotes, exchange prices, over the counter prices and time value. TEP and MEG's derivative activities are reported as follows:
INCOME STATEMENT LINE ------------------------------------------------------------------------ NET UNREALIZED GAINS NET REALIZED GAINS AND LOSSES AND LOSSES - -------------------------------------------- -------------------------------------- --------------------------------- TEP Forward Sales Contracts Electric Wholesale Sales Electric Wholesale Sales TEP Forward Purchase Contracts Purchased Power Purchased Power TEP Commodity Price Swaps Other Comprehensive Income Fuel Expense (Balance Sheet) MEG Trading Activities Other Operating Revenues Other Operating Revenues - -------------------------------------------- -------------------------------------- ---------------------------------
Although MEG's realized gains and losses on trading activities are reported net on UniSource Energy's income statement, the related cash receipts and cash payments are reported separately on UniSource Energy's statement of cash flows. The net pre-tax gains and losses from TEP and MEG's derivative activities for the three months ended and six months ended June 30, 2005 and 2004, were as follows: 19 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) - --------------------------------------------------------------------------------
Three Months Ended June 30, ----------------------------------- 2005 2004 - ---------------------------------------------------------------------------- ------------------ ---------------- -Millions of Dollars- TEP: Net Unrealized Loss on Forward Purchase Contracts $ (1) $ - Net Unrealized Loss on Commodity Price Swaps (1) 1 Net Realized Gain on Commodity Price Swaps 1 - MEG: Net Loss from Trading Activities (1) - - ---------------------------------------------------------------------------- ------------------ ----------------
Six Months Ended June 30, ----------------------------------- 2005 2004 - ---------------------------------------------------------------------------- ------------------ ---------------- -Millions of Dollars- TEP: Net Unrealized (Loss) Gain on Forward Sales Contracts $ (1) $ 1 Net Unrealized Gain on Commodity Price Swaps 4 2 Net Realized Gain on Commodity Price Swaps 1 - MEG: Net Loss from Trading Activities (1) - - ---------------------------------------------------------------------------- ------------------ ----------------
TEP and MEG's derivative assets and liabilities are reported as follows:
BALANCE SHEET LINE ----------------------------------------------------- ASSETS LIABILITIES - -------------------------------------------------------------------- ------------------------- --------------------------- TEP - Current Other Current Assets Other Current Liabilities TEP - Noncurrent Other Assets Other Liabilities MEG - Current (including Emissions Allowance Inventory) Trading Assets Trading Liabilities MEG - Noncurrent Other Assets Other Liabilities - -------------------------------------------------------------------- ------------------------- ---------------------------
The fair value of TEP and MEG's derivative assets and liabilities were as follows:
June 30, December 31, 2005 2004 - ----------------------------------------------------------------- ----------------------- ------------------------ -Millions of Dollars- TEP: Derivative Assets - Current $ 3 $ 2 Derivative Assets - Noncurrent 4 1 MEG: Trading Assets - Current 12 71 Trading Assets - Noncurrent 6 6 Trading Liabilities - Current (14) (65) - ----------------------------------------------------------------- ----------------------- ------------------------
The settlement of forward purchase and sales contracts that do not result in physical delivery are recorded net as a component of Electric Wholesale Sales in TEP's income statement. For the three months ended June 30, 2005, $4 million in sales were netted against $4 million in purchases. For the six months ended June 30, 2005, $9 million in sales were netted against $8 million in purchases and for the six months ended June 30, 2004, $2 million in sales were netted against $2 million in purchases. 20 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) - -------------------------------------------------------------------------------- NOTE 6. COMMITMENTS AND CONTINGENCIES - ------------------------------------- TEP CONTINGENCIES LITIGATION AND CLAIMS RELATED TO SAN JUAN GENERATING STATION Public Service Company of New Mexico (PNM), operator of San Juan, and the coal supplier to San Juan have been participating in sessions sponsored by the Environmental Protection Agency (EPA) to consider rulemaking for the disposal of coal combustion products due to claims by third parties that San Juan has contaminated water resources in the region as a result of disposing of fly ash in the surface mine pits adjacent to the generating station. In November 2004, a contractor for the EPA released a non-binding preliminary determination that any contamination at San Juan cannot be conclusively attributed to the disposal of fly ash; however, the EPA has not made a final determination. TEP owns 50% of San Juan Units 1 and 2, which equates to 19.8% of the total San Juan Generating Station. TEP does not believe that this issue will have a material adverse impact on TEP or its operations. LITIGATION AND CLAIMS RELATED TO NAVAJO GENERATING STATION On October 15, 2004, Peabody Western Coal Company (Peabody), the coal supplier to the Navajo Generating Station, filed a complaint in the Circuit Court for the City of St. Louis, Missouri against the participants at Navajo, including TEP, for reimbursement of royalties and other costs and breach of the coal supply agreement. The case was removed to Federal District Court Eastern District of Missouri on February 10, 2005. Peabody subsequently filed a motion to remand to superior court. Because TEP owns 7.5% of the Navajo Generating Station, its share of the current claimed damages would be approximately $35 million. TEP believes these claims are without merit and intends to continue to contest them. POSTRETIREMENT AND PENSION BENEFIT COSTS AT NAVAJO GENERATING STATION In 1996, Peabody filed a lawsuit in Maricopa County Superior Court against the participants at Navajo Generating Station, including TEP, for postretirement benefit costs payable to the coal supplier's employees under the coal supply agreements. The Navajo participants and Peabody have agreed to stay the discovery process in this litigation until August 31, 2005 to allow the parties additional time to negotiate a potential settlement. To the extent that amounts become estimable and payment probable, TEP will record a liability for additional postretirement benefit costs at the Navajo Generating Station. TEP does not expect any settlement to be material to TEP. TEP has previously settled claims for postretirement benefit costs with the coal suppliers at Springerville Generating Station and Four Corners Generating Station. The cost of postretirement benefits is included in the cost of coal to San Juan. ENVIRONMENTAL RECLAMATION AT REMOTE GENERATING STATIONS TEP currently pays on-going reclamation costs related to the coal mines which supply the remote generating stations, and it is probable that TEP will have to pay a portion of final reclamation costs upon mine closure. When a reasonable estimate of final reclamation costs is available, the liability is recognized as a cost of coal over the remaining term of the respective coal supply agreement. TEP estimates its undiscounted final reclamation liability to be $42 million, and the present value of TEP's liability for final reclamation approximates $12 million at the expiration dates of the coal supply agreements. At June 30, 2005 and December 31, 2004, TEP had recorded $1 million of its post-term reclamation liability, which is included in Other Liabilities in the balance sheets. Amounts recorded for final reclamation are subject to various assumptions and determinations, such as estimating the costs of reclamation, estimating when final reclamation will occur, and the credit-adjusted risk-free interest rate to be used to discount future liabilities. Changes that may arise over time with regard to these assumptions and determinations will change amounts recorded in the future as expense for post-term reclamation. TEP does not believe that recognition of its final reclamation obligations will be material to TEP in any single year since recognition occurs over the remaining lives of its coal supply agreements. 21 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) - -------------------------------------------------------------------------------- RESOLUTION OF SPRINGERVILLE GENERATING STATION COMPLAINT Environmental activist groups have expressed concerns regarding the construction of any new units at the Springerville Generating Station. In January 2003, environmental activist groups appealed an ACC Order affirming the ACC's approval of the expansion at the Springerville Generating Station to the Superior Court of the State of Arizona. On October 22, 2003, the Superior Court affirmed the ACC's issuance of the Certificate of Environmental Compatibility for Springerville Generating Station. The environmental activist groups appealed the Superior Court decision on December 30, 2003 and filed an amended notice of appeal on January 2, 2004 with the Arizona Court of Appeals. In February 2005, the Arizona Court of Appeals upheld the lower court's ruling affirming the ACC's approval of the expansion at Springerville Generating Station. In February 2005, the Grand Canyon Trust (GCT), one of the environmental activist groups with this appeal, and TEP reached a settlement under which the GCT will drop all claims against TEP regarding Springerville Generating Station. TEP will implement new emission limits at Units 1 and 2 by January 1, 2006. The Supreme Court of Arizona denied the other environmental activist group's petition for review on June 28, 2005. MILLENNIUM CONTINGENCY - NATIONS ENERGY In September 2001, Nations Energy Corporation (Nations Energy) sold its equity interest in a power project to a subsidiary of Mirant Corporation (Mirant). Nations Energy received $5 million in cash and an $11 million note receivable from Mirant. The note was recorded at its net present value of $8 million. As of June 30, 2005, Nations Energy's receivable from Mirant is approximately $9 million. The first payment of $2 million on the receivable was received in June 2004 and the second payment of $4 million was received in July 2005. The remaining payment of $5 million is expected to be received in July 2006. Nations Energy expects to collect the note in its entirety. MILLENNIUM COMMITMENT In April 2005, Millennium committed to fund $3 million to Battco, Inc., a company formed to carry on the business of IPS. GUARANTEES AND INDEMNITIES In the normal course of business, UniSource Energy and certain subsidiaries enter into various agreements providing financial or performance assurance to third parties on behalf of certain subsidiaries. We enter into these agreements primarily to support or enhance the creditworthiness of a subsidiary on a stand-alone basis. The most significant of these guarantees are: o UES' guarantee of $160 million of aggregate principal amount of senior unsecured notes issued by UNS Gas and UNS Electric to purchase the Citizens Arizona gas and electric utility assets, o UES' guarantee of a $40 million unsecured revolving credit agreement for UNS Gas and UNS Electric, o UniSource Energy's guarantee of approximately $8 million in natural gas transportation and supply payments in addition to building and equipment lease payments for UNS Gas, UNS Electric, and subsidiaries of Millennium, and o Millennium's guarantee of approximately $3 million in commodity-related payments for MEG and building lease payments for a subsidiary. In addition, UniSource Energy and its subsidiaries have indemnified the purchasers of interests in certain investments from additional taxes due for years prior to the sale of such investments. The terms of the indemnifications provide for no limitation on potential future payments; however, we believe that we have abided by all tax laws and paid all tax obligations. We have not made any payments under the terms of these indemnifications to date. We believe that the likelihood UniSource Energy, UES, or Millennium would be required to perform or otherwise incur any significant losses associated with any of these guarantees or indemnities is remote. 22 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) - -------------------------------------------------------------------------------- NOTE 7. TEP WHOLESALE ACCOUNTS RECEIVABLE AND ALLOWANCES - -------------------------------------------------------- TEP's Accounts Receivable from Electric Wholesale Sales, included in Trade Accounts Receivable on the balance sheet, totaled $21 million at June 30, 2005 and $22 million at December 31, 2004, net of allowances. TEP's Allowance for Doubtful Accounts on the balance sheet includes $13 million at June 30, 2005 and $13 million at December 31, 2004 related to sales to the California Power Exchange (CPX) and the California Independent System Operator (CISO) in 2001 and 2000. Excluding the receivables from the CPX and the CISO, substantially all of the June 30, 2005 and the December 31, 2004 wholesale receivable balances have been collected as of the date of this filing. In May 2004, the FERC issued two separate orders addressing numerous issues in the refund calculation and the fuel cost allowance calculation (an offset to the refund obligation). Based on these new orders, TEP increased its reserve for sales to the CPX and the CISO by $3 million by recording a reduction of wholesale revenues. There are several other outstanding legal issues, complaints and lawsuits concerning the California energy crisis related to the FERC, wholesale power suppliers, Southern California Edison Company, Pacific Gas and Electric Company, the CPX and the CISO. We cannot predict the outcome of these issues or lawsuits. We believe, however, that TEP is adequately reserved for its transactions with the CPX and the CISO. NOTE 8. UNISOURCE ENERGY EARNINGS PER SHARE (EPS) - ------------------------------------------------- Basic EPS is computed by dividing net income (loss) by the weighted average number of common shares outstanding during the period. Except when the effect would be anti-dilutive, the diluted EPS calculation includes the impact of shares that could be issued upon exercise of outstanding stock options, contingently issuable shares under equity-based awards or common shares that would result from the conversion of convertible notes. The numerator in calculating diluted earnings per share is net income (loss) adjusted for the interest on convertible notes (net of tax) that would not be paid if the notes were converted to common shares. The following table shows the effects of potential dilutive common stock on the weighted average number of shares:
Three Months Ended Six Months Ended June 30, June 30, 2005 2004 2005 2004 - ---------------------------------------------------------------------- ------------ ------------ ------------ ------------ - In Thousands - - In Thousands - Denominator: Weighted-average Shares of Common Stock Outstanding 34,807 34,392 34,721 34,288 Effect of Dilutive Securities: Convertible Senior Notes 4,000 - - - Options and Stock Issuable under Employee Benefit Plans and the Directors' Plan 698 663 722 683 - ---------------------------------------------------------------------- ------------ ------------ ------------ ------------ Total Shares 39,505 35,055 35,443 34,971 ====================================================================== ============ ============ ============ ============
Dilutive shares for the six months ended June 30, 2005 exclude 3,063 average incremental common shares related to options, contingently issuable shares and Convertible Senior Notes because they are antidilutive. NOTE 9. EMPLOYEE BENEFITS PLANS - ------------------------------- PENSION BENEFIT PLANS TEP, UNS Gas and UNS Electric maintain noncontributory, defined benefit pension plans for substantially all regular employees and certain affiliate employees. Benefits are based on years of service and the employee's average compensation. TEP, UNS Gas and UNS Electric fund the plans by contributing at least the minimum amount required under Internal Revenue Service regulations. Additionally, we provide supplemental retirement benefits to certain employees whose benefits are limited by Internal Revenue Service benefit or compensation limitations. 23 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) - -------------------------------------------------------------------------------- OTHER POSTRETIREMENT BENEFIT PLANS TEP provides limited health care and life insurance benefits for retirees. All regular employees may become eligible for these benefits if they reach retirement age while working for TEP or an affiliate. UNS Gas and UNS Electric provide postretirement medical benefits for current retirees and a small group of active employees. The majority of UNS Gas and UNS Electric employees do not participate in the postretirement medical plan. The ACC allows TEP, UNS Gas and UNS Electric to recover postretirement costs through rates only as benefit payments are made to or on behalf of retirees. The postretirement benefits are currently funded entirely on a pay-as-you-go basis. Under current accounting guidance, TEP, UNS Gas and UNS Electric cannot record a regulatory asset for the excess of expense calculated per Statement of Financial Accounting Standards No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, over actual benefit payments. COMPONENTS OF NET PERIODIC BENEFIT COST The components of net periodic benefit costs are as follows:
OTHER POSTRETIREMENT PENSION BENEFITS BENEFITS ----------------------------------------------------- Three Months Ended Three Months Ended June 30, June 30, 2005 2004 2005 2004 - --------------------------------------------------------------------------------------------------------- -Millions of Dollars - COMPONENTS OF NET PERIODIC BENEFIT COST Service Cost $ 2 $ 2 $ 1 $ 1 Interest Cost 3 2 1 1 Expected Return on Plan Assets (3) (3) - - Prior Service Cost Amortization - 1 - - Recognized Actuarial (Gain) Loss 1 - - - - --------------------------------------------------------------------------------------------------------- NET PERIODIC BENEFIT COST $ 3 $ 2 $ 2 $ 2 =========================================================================================================
OTHER POSTRETIREMENT PENSION BENEFITS BENEFITS ----------------------------------------------------- Six Months Ended Six Months Ended June 30, June 30, 2005 2004 2005 2004 - --------------------------------------------------------------------------------------------------------- -Millions of Dollars - COMPONENTS OF NET PERIODIC BENEFIT COST Service Cost $ 3 $ 3 $ 1 $ 1 Interest Cost 6 5 2 2 Expected Return on Plan Assets (6) (5) - - Prior Service Cost Amortization 1 1 (1) (1) Recognized Actuarial (Gain) Loss 2 - 1 1 - --------------------------------------------------------------------------------------------------------- NET PERIODIC BENEFIT COST $ 6 $ 4 $ 3 $ 3 =========================================================================================================
24 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) - -------------------------------------------------------------------------------- NOTE 10. SHARE-BASED COMPENSATION PLANS - --------------------------------------- UniSource Energy has issued equity-based compensation awards under the Directors' Plan and the Omnibus Plan. After February 4, 2004, no new awards can be granted under the Omnibus Plan. Effective January 1, 2005, we adopted the accounting for our share-based plans. Prior to January 1, 2005, we accounted for those plans under the recognition and measurement principles of APB 25. See Note 1. At June 30, 2004, we had stock options, stock units and restricted stock grants outstanding as discussed below. STOCK OPTIONS There were no stock options granted during the six months ended June 30, 2005 and June 30, 2004. Director stock option awards granted in 2003 vest over three years, become exercisable in one-third increments on each anniversary date of the grant and expire on the tenth anniversary of the grant. A summary of the stock option activity of the Directors' Plan and Omnibus Plan is as follows:
Six Months Ended June 30, 2005 2004 - -------------------------------------------------------------------------------------------------------- WEIGHTED Weighted AVERAGE Average EXERCISE Exercise SHARES PRICE Shares Price - -------------------------------------------------------------------------------------------------------- Options Outstanding, Beginning of Period 2,076,055 $ 16.19 2,478,551 $ 16.04 Granted - - - - Exercised (366,409) $ 16.12 (360,166) $ 15.12 Forfeited (7,198) $ 18.08 (2,613) $ 13.86 ----------------- ---------------- Options Outstanding, End of Period 1,702,448 $16.20 2,115,772 $ 16.20 ================= ================ Options Exercisable, End of Period 1,694,976 $16.19 2,092,169 $ 16.18 Weighted Average Remaining Contractual Life at June 30, 2005: 5.24 years - --------------------------------------------------------------------------------------------------------
Stock options awarded on January 1, 2002 accrue dividend equivalents that are paid in cash on the earlier of the date of exercise of the underlying option or the date the option expires. Compensation expense is recognized as dividends are declared. We recorded compensation expense of less than $0.2 million for each of the three and six-month periods ended June 30, 2005 and 2004. RESTRICTED STOCK AND STOCK UNITS There were no restricted stock awards granted during each of the three months ended June 30, 2005 and 2004. For the three months ended March 31, 2005 and 2004, we granted restricted stock awards to directors totaling 6,528 shares and 6,480 shares, respectively. The grant date fair value of the shares was $24.51 per share in 2005 and $24.68 per share in 2004. Directors may elect to receive stock units in lieu of restricted shares. The restricted shares or stock units become 100% vested on the third anniversary of the grant date. Compensation expense equal to the fair market value on the date of the award is recognized over the vesting period. We recorded compensation expense of less than $0.1 million for each of the three and six-month periods ended June 30, 2005 and 2004. There were no new stock unit awards granted under the Omnibus Plan during each of the six months ended June 30, 2005 and 2004. All stock unit awards previously issued under the Omnibus Plan had fully vested as of March 6, 2004. We recognized compensation expense related to earlier awards of less than $0.1 million in the first quarter of 2004. 25 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) - -------------------------------------------------------------------------------- Fully vested but undistributed stock unit awards accrue dividend equivalent stock units based on the fair market value of common shares on the date the dividend is paid. Compensation expense is recognized when dividends are declared. We recorded compensation expense of less than $0.1 million for each of the three and six-month periods ended June 30, 2005 and 2004. PERFORMANCE SHARES In May 2003, the Board of Directors approved a grant of performance shares to key employees under the Omnibus Plan. The shares were to be awarded at the end of a three-year performance period based on goal attainment. The grant date fair value was $17.84 per share. Compensation expense was initially recorded over the performance period based on the anticipated number and market value of shares to be awarded. As a result of the shareholder vote to approve the proposed merger, 53,566 performance shares vested and were distributed in March, 2004. See the 2004 Annual Report on Form 10-K, Note 17 of Notes to Consolidated Financial Statements - Stock-Based Compensation Plans. Compensation expense of $2 million was recorded for the three months ended March 31, 2004, for this award. NOTE 11. INCOME AND OTHER TAXES - -------------------------------- INCOME TAXES The differences between the income tax expense and the amount obtained by multiplying pre-tax income by the U.S. statutory federal income tax rate of 35% are as follows:
UNISOURCE ENERGY ------------------------------------------------------------ Three Months Ended Six Months Ended June 30, June 30, 2005 2004 2005 2004 - ------------------------------------------------------------------------------------------------------------------------- -Thousands of Dollars - FEDERAL INCOME TAX EXPENSE AT STATUTORY RATE $ 5,826 $ 8,560 $ 3,968 $ 12,875 State Income Tax Expense, Net of Federal Deduction 766 1,125 522 1,692 Depreciation Differences (Flow Through Basis) 736 789 1,416 1,578 Tax Credits (130) (129) (261) (258) Other (20) 1,310 7 1,677 - ------------------------------------------------------------------------------------------------------------------------- TOTAL FEDERAL AND STATE INCOME TAX EXPENSE $ 7,178 $ 11,655 $ 5,652 $ 17,564 =========================================================================================================================
TEP ------------------------------------------------------------ Three Months Ended Six Months Ended June 30, June 30, 2005 2004 2005 2004 - ------------------------------------------------------------------------------------------------------------------------- -Thousands of Dollars - FEDERAL INCOME TAX EXPENSE AT STATUTORY RATE $ 7,385 $ 11,500 $ 4,986 $ 12,504 State Income Tax Expense, Net of Federal Deduction 971 1,511 655 1,643 Depreciation Differences (Flow Through Basis) 736 789 1,416 1,578 Tax Credits (130) (129) (261) (258) Other (11) 1,170 (7) 1,448 - ------------------------------------------------------------------------------------------------------------------------- TOTAL FEDERAL AND STATE INCOME TAX EXPENSE $ 8,951 $ 14,841 $ 6,789 $ 16,915 =========================================================================================================================
The total Federal and State Income Tax Expense in the table above is included in UniSource Energy and TEP's income statements. 26 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) - -------------------------------------------------------------------------------- OTHER TAXES TEP, UNS Gas and UNS Electric act as conduits or collection agents for excise tax (sales tax) as well as franchise fees and regulatory assessments. They record liabilities payable to governmental agencies when they bill their customers for these amounts. Neither the amounts billed nor payable are reflected in the income statement. NOTE 12. NEW ACCOUNTING PRONOUNCEMENTS - -------------------------------------- The FASB recently issued the following Statements of Financial Accounting Standards (FAS), FASB Interpretations (FIN), and FASB Staff Positions (FSP): o FIN 47, Accounting for Conditional Asset Retirement Obligations, issued March 2005, provides guidance for a legal obligation to perform an asset retirement activity in which the timing and (or) method of settlement are conditional on a future event that may or may not be within the control of the entity. The obligation to perform the asset retirement activity is unconditional even though uncertainty exists about the timing and (or) method of settlement. FIN 47 requires a liability be recognized for the fair value of a conditional asset retirement obligation if the fair value can be reasonably estimated. FIN 47 is required to be applied by December 31, 2005. We are evaluating the impact on our financial position and results of operations of the adoption of FIN 47. o FSP FIN 46(R)-5, Implicit Variable Interests under FASB Interpretation No. 46 (revised December 2003), Consolidation of Variable Interest Entities, issued March 2005, addresses whether a reporting enterprise should consider whether it holds an implicit variable interest in a variable interest entity (VIE) or potential VIE when specific conditions exist. The guidance in FSP FIN 46(R)-5 was effective April 1, 2005, and did not have a significant impact on our financial statements. o FAS 151, Inventory Costs, issued November 2004, is an amendment of Accounting Research Bulletin (ARB) No. 43, Chapter 4, Inventory Pricing. FAS 151 clarifies that abnormal amounts of idle facility expense, freight, handling costs, and wasted materials (spoilage) should be recognized as current-period charges. FAS 151 also requires the allocation of fixed production overheads to inventory based on the normal capacity of the production facilities. FAS 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The adoption of FAS 151 is not expected to have a significant impact on our financial statements. o FAS 153, Exchanges of Nonmonetary Assets, issued December 2004, requires nonmonetary exchanges be accounted for at fair value, recognizing any gains or losses, if their fair value is determinable within reasonable limits and the transaction has commercial substance. A nonmonetary exchange has commercial substance if future cash flows of the entity are expected to change significantly as a result of the exchange. FAS 153 is effective for nonmonetary asset exchange transactions occurring in fiscal periods beginning after June 15, 2005. The adoption of FAS 153 is not expected to have a significant impact on our financial statements. o FAS 154, Accounting Changes and Error Corrections, issued May 2005, provides guidance on the accounting for and reporting of accounting changes and error corrections. FAS 154 requires retrospective application to prior periods for a voluntary change in accounting principle, unless it is impracticable to do so. FAS 154 also provides guidance related to the reporting of a change in accounting estimate, a change in reporting entity and the correction of an error. FAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The adoption of FAS 154 is not expected to have a significant impact on our financial statements. o FSP FAS 109-1, Application of FASB Statement No. 109, Accounting for Income Taxes, to the Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of 2004, issued in December 2004, provides guidance on the application of FAS 109 to the provision within the American Jobs Creation Act of 2004 that provides a tax deduction, beginning in 2005, on qualified production activities, including a company's electric generation activities. Under FSP FAS 109-1, recognition of the tax deduction on qualified production activities is ordinarily reported in the year it is earned. FSP FAS 109-1 did not have an impact on our financial statements in the first six months of 2005. We are evaluating the impact of FSP FAS 109-1 on our financial position and results of operations for the remainder of the year. In June 2004, the EITF published Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments (EITF 03-1). EITF 03-1 provides application guidance on impairment of 27 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) - -------------------------------------------------------------------------------- securities accounted for under FAS 115, Accounting for Certain Investments in Debt and Equity Securities, and cost method investments and requires certain quantitative and qualitative disclosures for securities that are impaired at the balance sheet date but for which an other-than-temporary impairment has not been recognized. The disclosure requirements are effective for reporting periods ending after December 31, 2003. The FASB issued FSP EITF Issue 03-1-1, Effective Date of Paragraphs 10-20 of EITF Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments in September 2004 delaying the effective date of the application guidance on impairment of securities until the final issuance of FSP EITF Issue 03-1-a. As of August 4, 2005, a final FSP EITF Issue 03-1-a has not been issued. The adoption of EITF 03-1 is not expected to have a significant impact on our financial statements. NOTE 13. SUPPLEMENTAL CASH FLOW INFORMATION - ------------------------------------------- A reconciliation of net income to net cash flows from operating activities follows:
UNISOURCE ENERGY -------------------------------- Six Months Ended June 30, 2005 2004 - -------------------------------------------------------------------------------- ---------------- --------------- -Thousands of Dollars- NET INCOME $ 5,685 $ 19,222 ADJUSTMENTS TO RECONCILE NET INCOME TO NET CASH FLOWS Depreciation and Amortization Expense 68,168 71,696 Depreciation Recorded to Fuel and Other O&M Expense 2,765 3,098 Amortization of Transition Recovery Asset 23,623 20,600 Net Unrealized Loss (Gain) on TEP Forward Electric Sales 1,088 (780) Net Unrealized Gain on MEG Trading Activities (7,143) (1,689) Amortization of Deferred Debt-Related Costs included in Interest Expense 2,004 1,660 Loss on Reacquired Debt 5,427 1,635 Provision for Bad Debts 1,372 1,734 Deferred Income Taxes 10,587 3,200 Loss (Gain) from Equity Method Entities 687 (5,418) Other 14,302 17,956 Changes in Assets and Liabilities which Provided (Used) Cash Exclusive of Changes Shown Separately Accounts Receivable 3,000 (16,979) Materials and Fuel Inventory (6,257) (255) Accounts Payable (28,093) 6,037 Interest Accrued (3,767) (2,182) Taxes Accrued (18,447) 15,281 Other Current Assets 69,515 (39,263) Other Current Liabilities (53,196) 45,683 - -------------------------------------------------------------------------------- ---------------- --------------- NET CASH FLOWS - OPERATING ACTIVITIES $ 91,320 $ 141,236 ================================================================================ ================ ===============
28 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONCLUDED) - --------------------------------------------------------------------------------
TEP -------------------------------- Six Months Ended June 30, 2005 2004 - -------------------------------------------------------------------------------- ---------------- --------------- -Thousands of Dollars- NET INCOME $ 7,458 $ 18,811 ADJUSTMENTS TO RECONCILE NET INCOME TO NET CASH FLOWS Depreciation and Amortization Expense 57,954 62,438 Depreciation Recorded to Fuel and Other O&M Expense 3,180 3,098 Amortization of Transition Recovery Asset 23,623 20,600 Net Unrealized Loss (Gain) on TEP Forward Electric Sales 1,088 (780) Amortization of Deferred Debt-Related Costs included in Interest Expense 1,823 1,506 Loss on Reacquired Debt 5,427 1,635 Provision for Bad Debts 1,052 813 Deferred Income Taxes 10,328 7,686 Gains from Equity Method Entities (45) (62) Interest on Note Receivable from UniSource Energy (1,684) (4,639) Other 11,953 21,361 Changes in Assets and Liabilities which Provided (Used) Cash Exclusive of Changes Shown Separately Accounts Receivable (17,748) (23,162) Materials and Fuel Inventory (4,068) 1,469 Accounts Payable (12,438) 5,872 Interest Accrued (6,668) (1,983) Interest Received from UniSource Energy 11,013 - Income Tax Receivable (1,227) - Taxes Accrued (15,965) 5,605 Other Current Assets 1,951 (1,105) Other Current Liabilities (3,174) (570) - -------------------------------------------------------------------------------- ---------------- --------------- NET CASH FLOWS - OPERATING ACTIVITIES $ 73,833 $ 118,593 ================================================================================ ================ ===============
NOTE 14. SUBSEQUENT EVENT - ------------------------- In July 2005, Millennium received $4 million as a return of its investment in Carboelectrica Sabinas, S. de R.L. de C.V., (Sabinas) a Mexican limited liability company. As a result of the $4 million payment, the book value of the investment in Sabinas was reduced to approximately $14 million. Millennium owns 50% of Sabinas. NOTE 15. REVIEW BY INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM - ---------------------------------------------------------------- With respect to the unaudited condensed consolidated financial information of UniSource Energy and TEP for the three-month and six-month periods ended June 30, 2005 and 2004, PricewaterhouseCoopers LLP reported that they have applied limited procedures in accordance with professional standards for a review of such information. However, their separate report dated August 8, 2005, appearing herein states that they did not audit and they do not express an opinion on that unaudited condensed consolidated financial information. Accordingly, the degree of reliance on their report on such information should be restricted in light of the limited nature of the review procedures applied. PricewaterhouseCoopers LLP is not subject to the liability provisions of Section 11 of the Securities Act of 1933 (the Act) for their report on the unaudited condensed consolidated financial information because that report is not a "report" or a "part" of a registration statement prepared or certified by PricewaterhouseCoopers LLP within the meaning of Sections 7 and 11 of the Act. 29 ITEM 2.- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - -------------------------------------------------------------------------------- Management's Discussion and Analysis explains the results of operations, the general financial condition, and the outlook for UniSource Energy and its four primary business segments and includes the following: o outlook and strategies, o operating results during the second quarter and first six months of 2005 compared with the same periods in 2004, o factors which affect our results and outlook, o liquidity, capital needs, capital resources, and contractual obligations, o dividends, and o critical accounting estimates. Management's Discussion and Analysis should be read in conjunction with UniSource Energy and TEP's 2004 Annual Report on Form 10-K and with the Condensed Consolidated Financial Statements, beginning on page 2, which present the results of operations for the three and six months ended June 30, 2005, and 2004. Management's Discussion and Analysis explains the differences between periods for specific line items of the Condensed Consolidated Financial Statements. References in this report to "we" and "our" are to UniSource Energy and its subsidiaries, collectively. UNISOURCE ENERGY CONSOLIDATED OVERVIEW OF CONSOLIDATED BUSINESS UniSource Energy is a holding company that has no significant operations of its own. Operations are conducted by UniSource Energy's subsidiaries, each of which is a separate legal entity with its own assets and liabilities. UniSource Energy owns substantially all of the outstanding common stock of TEP, and all of the outstanding common stock of UniSource Energy Services, Inc. (UES), Millennium Energy Holdings, Inc. (Millennium), and UniSource Energy Development Company (UED). TEP, an electric utility, has provided electric service to the community of Tucson, Arizona, for over 100 years. UES began operations in August 2003. UES, through its two operating subsidiaries, UNS Gas, Inc. (UNS Gas) and UNS Electric, Inc. (UNS Electric), provides gas and electric service to 30 communities in northern and southern Arizona. Millennium invests in unregulated businesses, including Global Solar Energy, Inc. (Global Solar), a developer and manufacturer of thin-film photovoltaic cells and modules. UED engages in developing generating resources and other project development activities, including facilitating the expansion of the Springerville Generating Station, but has no significant operations. We conduct our business in four primary business segments - TEP's Electric Utility segment, UNS Gas, UNS Electric and Global Solar. UniSource Energy was incorporated in the State of Arizona on March 8, 1995, and obtained regulatory approval to form a holding company in November 1997. On January 1, 1998, TEP and UniSource Energy exchanged shares of stock resulting in TEP becoming a subsidiary of UniSource Energy. Following the share exchange, TEP transferred the stock of its subsidiary Millennium to UniSource Energy. OUTLOOK AND STRATEGIES - ---------------------- OPERATING PLANS AND STRATEGIES Our financial prospects and outlook for the next few years will be affected by many competitive, regulatory and economic factors. Our plans and strategies include the following: o Continue to integrate UES' businesses with UniSource Energy's other businesses. o Oversee the construction of Springerville Unit 3 and continue to enhance the value of existing assets by working with Salt River Project to facilitate the development of Springerville Unit 4. 30 o Reduce UniSource Energy's debt, using some of our excess cash flows. o Enhance the value of TEP's transmission system while continuing to provide reliable access to generation for TEP and UES' retail customers and market access for all generating assets. o Promote economic development in our service territories. o Efficiently manage our generation, transmission and distribution resources and look for ways to control our operating expenses while maintaining and enhancing reliability and profitability. o Expand TEP's and UNS Electric's portfolio of generating and purchased power resources to meet growing retail energy demand. o Increase production and sales of Global Solar's thin-film photovoltaic cells and seek additional investors, or sell all or part of Millennium's interest, or a combination of both. o Manage the exit of our other Millennium investments to maximize their value to shareholders. To accomplish our goals, during 2005 we expect to spend the following amounts on capital expenditures:
Actual Year-to-Date Estimate June 30, 2005 Full Year 2005 - -------------------- ------------------------ -------------------- -Millions of Dollars- TEP $68 $153 UNS Gas 13 23 UNS Electric 9 34 - -------------------- ------------------------ --------------------
While we believe that our plans and strategies will continue to have a positive impact on our financial prospects and position, we recognize that we continue to be highly leveraged, and as a result, our access to the capital markets may be limited or more expensive than for less leveraged companies. RESULTS OF OPERATIONS - --------------------- THREE MONTHS ENDED JUNE 30, 2005 COMPARED WITH THE THREE MONTHS ENDED JUNE 30, 2004 UniSource Energy recorded net income of $9 million, or 27 cents per average basic share of Common Stock, in the second quarter of 2005, compared with net income of $13 million, or 37 cents per average basic share of Common Stock, in the same period of 2004. The following factors contributed to the decline: 2005 included: o a $6 million decrease in TEP's gross margin (the sum of retail and wholesale electric revenues less fuel and purchased power expense) due to the following: - an $8 million increase in purchased power expense due to higher replacement power costs resulting from planned coal plant maintenance outages and lost energy from the expiration of the Southern California Edison (SCE) Exchange in May 2005; and - a $4 million decline in wholesale revenues due to increased retail demand and the lower availability of excess power to sell into the wholesale market; partially offset by - a $6 million increase in retail revenues due to warmer weather and a 2% increase in TEP's customer base. o a $5 million increase in other operations and maintenance (O&M) expense primarily due to planned outages at TEP's coal-fired plants; and o a $4 million increase in total interest expense due to: expenses associated with fees written off for TEP's old Credit Agreement when it entered a new Credit Agreement in May 2005; the repurchase and redemption of $225 million of TEP debt in May 2005; and interest expense at UniSource Energy 31 stand-alone, related to convertible notes issued in March 2005 and the UniSource Energy Credit Agreement, entered into in April 2005; and o a $3 million decline in depreciation and amortization related to the extension of useful lives of certain generating assets at TEP in July 2004 and April 2005; and o a $3 million increase in other income due to lower expenses related to MEH investments. 2004 included: o a net loss of $1 million at UNS Gas. SIX MONTHS ENDED JUNE 30, 2005 COMPARED WITH THE SIX MONTHS ENDED JUNE 30, 2004 UniSource Energy recorded net income of $6 million, or 16 cents per average basic share of Common Stock, in the six months ended June 30, 2005, compared with net income of $19 million, or 56 cents per average basic share of Common Stock, in the same period of 2004. The following factors contributed to the decline: 2005 included: o an $18 million decrease in TEP's gross margin (the sum of retail and wholesale electric revenues less fuel and purchased power expense) due to the following: - a $15 million increase in purchased power expense due to higher replacement power costs resulting from planned coal plant maintenance outages and lost energy from the expiration of the SCE Exchange in May 2005; and - a $7 million decline in wholesale revenues due to increased retail demand and the lower availability of excess power to sell into the wholesale market; partially offset by - a $4 million increase in retail revenues due to warm weather during the second quarter and a 2% increase in TEP's customer base. o a $3 million increase in other O&M expense due to higher maintenance costs at TEP's coal-fired plants; o a $4 million decline in depreciation and amortization primarily related to the extension of useful lives of certain generating assets at TEP in July 2004 and April 2005; and o net income of $4 million at UNS Gas in the first six months of 2005 compared with net income of $3 million in the same period last year. 2004 included: o a $3 million after-tax gain at MEH from its investment in Haddington. 32 CONTRIBUTION BY BUSINESS SEGMENT The table below shows the contributions to our consolidated after-tax earnings by our four business segments.
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30, 2005 2004 2005 2004 - ----------------------------------------- ----------------------------- ---------------------------------- -Millions of Dollars- -Millions of Dollars- BUSINESS SEGMENT TEP $ 12 $ 18 $ 7 $ 19 UNS Gas - (1) 4 3 UNS Electric 1 1 1 2 Global Solar (2) (1) (3) (2) Other (1) (2) (4) (3) (3) - ----------------------------------------- -------------- -------------- --------------- ------------------ Consolidated Net Income $ 9 $ 13 $ 6 $ 19 ========================================= ============== ============== =============== ==================
(1) Includes: UniSource Energy parent company expenses, including in 2005, interest expense (net of tax) on the UniSource Energy Convertible Senior Notes, the UniSource Energy Credit Agreement, and on the note payable from UniSource Energy to TEP; and in 2004 includes costs associated with the proposed acquisition of UniSource Energy by Saguaro; income and losses from other Millennium investments; and income and losses from UED. LIQUIDITY AND CAPITAL RESOURCES - -------------------------------
UNISOURCE ENERGY CONSOLIDATED CASH FLOWS SIX MONTHS ENDED JUNE 30, 2005 2004 -Millions of Dollars- --------------------------------------- ---------------- --------------- Cash provided by (used in): Operating Activities $ 91 $ 141 Investing Activities (75) (57) Financing Activities (67) (56) --------------------------------------- ---------------- --------------- Net Increase (Decrease) in Cash $ (51) $ 28 ======================================= ================ ===============
UniSource Energy's consolidated cash flows are provided primarily from retail and wholesale energy sales at TEP, UNS Gas and UNS Electric, net of the related payments for fuel and purchased power. Generally, cash from operations is lowest in the first quarter and highest in the third quarter due to TEP's summer peaking load. We use our available cash primarily to: o finance capital expenditures at TEP, UNS Gas and UNS Electric; o pay dividends to shareholders; and o reduce leverage by repaying or repurchasing debt and investing in lease debt. The primary source of liquidity for UniSource Energy, the parent company, is dividends it receives from its subsidiaries, primarily TEP. Under our tax sharing agreement, our subsidiaries make income tax payments to UniSource Energy, which makes payments on behalf of the consolidated group. As of August 4, 2005, cash and cash equivalents available to UniSource Energy was approximately $113 million. OPERATING ACTIVITIES In the first six months of 2005, net cash flows from operating activities decreased by $50 million compared with the same period in 2004. The following factors contributed to the decrease: 33 2005 included: o an $8 million increase in cash receipts from electric and gas sales; offset by - a $6 million increase in fuel costs paid and a $28 million increase in purchased power costs paid due to planned outages at Springerville Unit 2 and San Juan Unit 2 and higher natural gas prices; o a $10 million increase in payments for O&M costs related to the planned outages at TEP's plants; o a $4 million increase in wages paid due to a greater number of employees, rising wage levels and higher incentive compensation; and o a $4 million decrease in total taxes paid, net of income tax refunds received, due to a smaller final tax payment related to prior year consolidated income tax returns. 2004 included: o $17 million received by TEP related to the return to TEP of a deposit for its 1992 Mortgage; and o $4 million in other cash receipts related to the sale of an investment by a Millennium subsidiary. INVESTING ACTIVITIES Net cash used for investing activities was $17 million higher in the first six months of 2005 compared with the same period in 2004, primarily due to the following factors: 2005 included: o a $19 million increase in capital expenditures due primarily to a planned maintenance outage at Springerville and TEP's share of the construction costs of the Luna Energy Facility; and o other cash receipts of $8 million due primarily to the redemption of a $5 million certificate of deposit at TEP. 2004 included: o $10 million received as a return on an MEH investment in Haddington and a payment received on a note receivable held by Nations Energy; and o a $4 million purchase of Springerville lease debt. FINANCING ACTIVITIES Net cash flows used for financing activities were $12 million higher in the first six months of 2005 compared with the same period in 2004. The following factors contributed to the change: 2005 included: o proceeds of $240 million related to UniSource Energy's issuance of $150 million of Convertible Senior Notes and borrowings of $90 million under its term loan; o borrowings under TEP's revolving credit facility of $40 million; o $282 million increase in repayments on long-term debt related to TEP's early redemption of $53 million of First Mortgage Bonds in the first three months of 2005, the repurchase and redemption of $225 million of fixed-rate tax exempt debt in May 2005 and a $1 million principal payment on the UniSource Energy term loan; o a $5 million increase in TEP's payments on capital lease obligations; and 34 o a $4 million increase in dividends paid to UniSource Energy shareholders. As a result of the activities described above, our consolidated cash and cash equivalents decreased to $103 million at June 30, 2005, from $154 million at December 31, 2004. We invest cash balances in high-grade money market securities with an emphasis on preserving the principal amounts invested. At August 4, 2005, our consolidated cash balance, including cash equivalents, was approximately $113 million. We believe that we will continue to have sufficient cash flow to cover our capital needs, as well as required debt payments and dividends to shareholders. In the event that we experience lower cash from operations in 2005, the Company will use its revolving credit facilities to fund its cash needs. Convertible Senior Notes ------------------------ In March 2005, UniSource Energy issued $150 million of 4.50% Convertible Senior Notes due 2035 in a private placement. The Convertible Senior Notes are unsecured and are not guaranteed by TEP or any other UniSource Energy subsidiary. Each $1,000 of Convertible Senior Notes is convertible into 26.6667 shares of our Common Stock at any time, representing a conversion price of approximately $37.50 per share of our Common Stock, subject to adjustment in certain circumstances. We will pay interest on the Convertible Senior Notes semi-annually, beginning on September 1, 2005. UniSource Credit Agreement -------------------------- In April 2005, UniSource Energy entered into a $105 million five-year credit agreement with a group of lenders (UniSource Credit Agreement) which expires on April 15, 2010. The UniSource Credit Agreement includes a $90 million term loan facility and a $15 million revolving credit facility. Quarterly principal payments of $1.25 million are due beginning June 30, 2005, with the balance due at maturity. We borrowed $80 million under the $90 million term loan on May 10, 2005, and the remaining $10 million on June 29, 2005. We made the required $1.25 million principal payment on June 30, 2005, leaving an outstanding balance on the term loan of $88.75 million. We pay interest on the term loan and on borrowings under the revolving credit facility at LIBOR plus 1.75% or the agent bank's reference rate plus 0.75%. We paid a commitment fee of 0.50% on the unused portion of the term loan until it was fully drawn at June 29, 2005, and pay a commitment fee of 0.50% on the unused portion of the revolving credit facility. The UniSource Credit Agreement restricts additional indebtedness, liens, mergers, sales of assets, and investments and acquisitions. We must also meet: (1) a minimum cash flow to interest coverage ratio for UniSource Energy on a standalone basis and (2) a maximum leverage ratio on a consolidated basis. We may pay dividends, if after giving effect to the dividend payment, we have more than $15 million of unrestricted cash and unused revolving credit. As of June 30, 2005, we were in compliance with the terms of the UniSource Credit Agreement. If an event of default occurs, the UniSource Credit Agreement may become immediately due and payable. An event of default includes failure to make required payments under the UniSource Credit Agreement, failure of UniSource Energy or certain subsidiaries to make payments or default on debt greater than $20 million, or certain bankruptcy events at UniSource Energy or certain subsidiaries. We expect that we may borrow from time to time under the revolving credit facility to meet temporary cash needs. As of June 30, 2005, we had no borrowings outstanding under the revolving credit facility. Use of Proceeds --------------- On March 1, 2005, we received $146 million of net proceeds from the sale of the Convertible Senior Notes, which was used as follows: o to repay our $95 million promissory note to TEP plus accrued interest of $11 million on March 1, 2005; 35 o to make a capital contribution of $6 million to UNS Gas and a capital contribution of $4 million to UNS Electric on March 10, 2005; and o to make a capital contribution of $110 million to TEP on May 10, 2005, using the remaining $30 million from the sale of the notes, along with $80 million of proceeds from the term loan. TEP used the proceeds from the capital contribution, the inter-company note repayment (described above), along with borrowings under its revolving credit facility to repurchase and redeem $225 million of fixed-rate tax-exempt debt obligations. See, Tucson Electric Power, Bond Repurchases and Redemptions, and Tucson Electric Power Company, Liquidity and Capital Resources, Dividends on Common Stock, below. GUARANTEES AND INDEMNITIES In the normal course of business, UniSource Energy and certain subsidiaries enter into various agreements providing financial or performance assurance to third parties on behalf of certain subsidiaries. We enter into these agreements primarily to support or enhance the creditworthiness of a subsidiary on a stand-alone basis. The most significant of these guarantees at June 30, 2005 are: - UES' guarantee of $160 million of senior unsecured notes issued by UNS Gas and UNS Electric to purchase the Citizens Communication Company (Citizens') Arizona gas and electric system assets; - UES' guarantee of a $40 million revolving credit facility available to UNS Gas and UNS Electric; - UniSource Energy's guarantee of approximately $8 million in natural gas and supply payments and building lease payments for UNS Gas and UNS Electric and subsidiaries of Millennium; and - Millennium's guarantee of approximately $3 million in commodity-related payments for MEG and building lease payments for a subsidiary. To the extent liabilities exist under the contracts subject to these guarantees, such liabilities are included in the consolidated balance sheets. In addition, UniSource Energy and its subsidiaries have indemnified the purchasers of interests in certain investments from additional taxes due for years prior to the sale. The terms of the indemnifications provide for no limitation on potential future payments; however, we believe that we have abided by all tax laws and paid all tax obligations. We have not made any payments under the terms of these indemnifications to date. We believe that the likelihood that UniSource Energy or TEP would be required to perform or otherwise incur any significant losses associated with any of these guarantees is remote. CONTRACTUAL OBLIGATIONS There are no significant changes in our contractual obligations or other commercial commitments from those reported in our 2004 Annual Report on Form 10-K, other than: the UniSource Energy Credit Agreement (described above); the repayment of debt obligations at TEP and the termination of TEP's 1941 Mortgage, described below; and the UNS Gas/UNS Electric Credit Agreement, described below. DIVIDENDS ON COMMON STOCK The following table shows the dividends declared to UniSource Energy shareholders for 2005.
DIVIDEND AMOUNT DECLARATION DATE RECORD DATE PAYMENT DATE PER SHARE OF COMMON STOCK - --------------------------- ------------------------- ---------------------------- ----------------------------------------- February 4, 2005 February 15, 2005 March 8, 2005 $0.19 May 6, 2005 May 18, 2005 June 10, 2005 0.19
36 INCOME TAX POSITION At June 30, 2005, UniSource Energy and TEP had, for federal and state income tax filing purposes, the following carryforward amounts:
UNISOURCE ENERGY TEP Amount Expiring Amount Expiring - ------------------------------ ---------------------- ------------- ----------------------- ------------- -Millions of Dollars- Year -Millions of Dollars- Year NET OPERATING LOSSES $ 18 2021-2022 $ - - INVESTMENT TAX CREDIT 5 2004-2024 5 2004-2024 AMT CREDIT 100 - 92 - - ------------------------------ ---------------------- ------------- ----------------------- -------------
The $18 million in NOL carryforwards is subject to limitation due to a reorganization of certain Millennium entities in December 2002. The future use of these losses is dependant upon the generation of sufficient future taxable income at the separate company level. See Critical Accounting Estimates, Deferred Tax Valuation - TEP and Millennium, below. TUCSON ELECTRIC POWER COMPANY RESULTS OF OPERATIONS - --------------------- The financial condition and results of operations of TEP are currently the principal factors affecting the financial condition and results of operations of UniSource Energy on an annual basis. The following discussion relates to TEP's utility operations, unless otherwise noted.
SALES OPERATING REVENUE THREE MONTHS ENDED JUNE 30, 2005 2004 2005 2004 -Millions of kWh- -Millions of Dollars- - --------------------------------------------- -------------- ------------- ------------ -------------- ELECTRIC RETAIL SALES: Residential 908 826 $ 84 $ 81 Commercial 498 478 52 51 Industrial 596 603 44 43 Mining 224 205 10 9 Public Authorities 66 66 5 5 - --------------------------------------------- -------------- ------------- ------------ -------------- TOTAL ELECTRIC RETAIL SALES 2,292 2,178 $ 195 $ 189 - --------------------------------------------- -------------- ------------- ------------ -------------- ELECTRIC WHOLESALE SALES DELIVERED: Long-term Contracts 277 282 12 13 Other Sales 477 654 24 27 Transmission - - 2 2 Net Unrealized Gain (Loss) on Forward Sales of Energy - - - - - --------------------------------------------- -------------- ------------- ------------ -------------- TOTAL ELECTRIC WHOLESALE SALES 754 936 38 42 - --------------------------------------------- -------------- ------------- ------------ -------------- TOTAL ELECTRIC SALES 3,046 3,114 $ 233 $ 231 ============================================= ============== ============= ============ ============== WEATHER DATA: 2005 2004 COOLING DEGREE DAYS Three Months Ended June 30, 454 402 10-Year Average 434 418 % Over / (Under) Prior Year 13% (15%) % Over / (Under) 10-Year Average 5% (4%) HEATING DEGREE DAYS Three Months Ended June 30, 31 57 10-Year Average 72 80 % Over / (Under) Prior Year (46%) (19%) % Over / (Under) 10-Year Average (132%) (29%) - --------------------------------------------- -------------- ------------- ------------ --------------
37 Total revenues from kWh sales to retail customers increased by $6 million, or 3%, in the second quarter of 2005 compared with the same period last year. Residential kWh sales increased 10% and commercial kWh sales increased 4%, benefiting from warmer weather and customer growth. Cooling degree days were 13% higher than last year and 5% above the 10-year average. The total number of retail customers as of June 30, 2005 was 379,964, up 2.4% from a year ago. The average price of copper during the second quarter of 2005 was $1.53 per pound, or 24% higher than the average price in the same period last year, leading to increased mining activity and a 9% increase in kWh sales to TEP's mining customers; revenues from TEP's mining customers increased $1 million. Total retail kWh sales increased by 5% in the second quarter of 2005 compared with the same period last year. Wholesale revenues decreased $4 million, or 10%, in the second quarter of 2005 compared with the second quarter of 2004. Wholesale sales opportunities were limited in the second quarter of 2005 due to higher retail energy demand and planned outages at the San Juan and Four Corners Generating Stations. The average wholesale market price of energy was $45 per MWh in the second quarter of 2005, compared with $44 per MWh in the comparable period in 2004. See Factors Affecting Results of Operations, Western Energy Markets, Market Prices, below.
SALES OPERATING REVENUE SIX MONTHS ENDED JUNE 30, 2005 2004 2005 2004 -Millions of kWh- -Millions of Dollars- - --------------------------------------------- -------------- ------------- ------------ -------------- ELECTRIC RETAIL SALES: Residential 1,558 1,544 $ 140 $ 139 Commercial 849 836 88 87 Industrial 1,108 1,093 79 79 Mining 444 398 21 18 Public Authorities 110 116 8 9 - --------------------------------------------- -------------- ------------- ------------ -------------- TOTAL ELECTRIC RETAIL SALES 4,069 3,987 $ 336 $ 332 - --------------------------------------------- -------------- ------------- ------------ -------------- ELECTRIC WHOLESALE SALES DELIVERED: Long-term Contracts 585 628 27 28 Other Sales 930 1,197 47 52 Transmission - - 4 4 Net Unrealized Gain (Loss) on Forward Sales of Energy - - (1) - - --------------------------------------------- -------------- ------------- ------------ -------------- TOTAL ELECTRIC WHOLESALE SALES 1,515 1,825 $ 77 $ 84 - --------------------------------------------- -------------- ------------- ------------ -------------- TOTAL ELECTRIC SALES 5,584 5,812 $ 413 $ 416 ============================================= ============== ============= ============ ============== WEATHER DATA: 2005 2004 COOLING DEGREE DAYS Six Months Ended June 30, 454 407 10-Year Average 434 418 % Over / (Under) Prior Year 12% (14%) % Over / (Under) 10-Year Average 9% (3%) HEATING DEGREE DAYS Six Months Ended June 30, 805 934 10-Year Average 880 876 % Over / (Under) Prior Year (14%) 24% % Over / (Under) 10-Year Average (9%) 7% - --------------------------------------------- -------------- ------------- ------------ --------------
Total revenues from kWh sales to retail customers increased by $4 million, or 1%, in the first six months of 2005 compared with the same period last year. Mild winter weather during the first quarter was offset by customer growth and warmer weather during the second quarter. Residential kWh sales increased 1% and commercial kWh sales increased 2% during the first six months of 2004. The average price of copper in the first six months of 2005 was $1.50 per pound, or 22% higher than the average price in first six months of 2004, leading to increased mining activity and a 12% increase in kWh sales to TEP's mining customers; revenues from TEP's mining customers increased $3 million. Total retail kWh sales increased by 2% in the first six months of 2005 compared with the same period last year. Wholesale revenues decreased $7 million, or 8%, in the first six months of 2005 compared with the same period in 2004. Planned outages at TEP's Springerville Unit 2 and San Juan Unit 2 limited wholesale sales 38 opportunities. The average wholesale market price of energy was $45 per MWh in the first six months 2005, compared with $42 per MWh in the comparable period in 2004. See Factors Affecting Results of Operations, Western Energy Markets, Market Prices, below. OPERATING EXPENSES FUEL AND PURCHASED POWER EXPENSE TEP's fuel and purchased power expense, and energy resources for the second quarters of 2005 and 2004 are shown in the table below.
GENERATION EXPENSE THREE MONTHS ENDED JUNE 30, 2005 2004 2005 2004 -Millions of kWh- -Millions of Dollars- - ---------------------------------------------------- ----------------------- ------------------------- Coal-Fired Generation 2,767 2,910 $ 48 $ 47 Gas-Fired Generation 89 98 8 8 - ---------------------------------------------------- --------- ------------- ------------ ------------- Total Generation 2,856 3,008 56 55 Purchased Power 416 328 27 19 - ---------------------------------------------------- --------- ------------- ------------ ------------- Total Resources 3,272 3,336 $ 83 $ 74 ============ ============= Less Line Losses, Company Use and Other 226 222 - ---------------------------------------------------- --------- ------------- Total Energy Sold 3,046 3,114 ==================================================== ========= =============
Total fuel expense at TEP's generating plants was $56 million in the second quarter of 2005, up $1 million from the same period last year, despite lower generating output. Coal-fired generation declined 143,000 MWh, or 5%, compared with the second quarter of 2004 due to maintenance outages at San Juan Unit 2, Four Corners Unit 5, as well as some minor unplanned outages at TEP's other coal plants. Gas-fired generation decreased by 9,000 MWh, however gas-related fuel expense was unchanged due to higher natural gas prices. Purchased power expense increased $8 million compared with the second quarter of 2004, due to an increase of 27%, or 88,000 MWh, in power purchases to replace energy lost from coal plant outages and the expiration of the SCE Exchange. In addition, the average wholesale market price for power increased 2% compared with the second quarter of 2004. The SCE Exchange expired in May 2005. The agreement required SCE to provide 110 MW of firm system capacity to TEP during the summer months (May through September) and for TEP to return to SCE in the winter months (November through February) the same amount of energy that TEP received during the preceding summer. See Factors Affecting Results of Operations, Western Energy Markets, Market Prices, below.
GENERATION EXPENSE SIX MONTHS ENDED JUNE 30, 2005 2004 2005 2004 -Millions of kWh- -Millions of Dollars- - ---------------------------------------------------- ----------------------- ------------------------- Coal-Fired Generation 5,172 5,673 $ 90 $ 94 Gas-Fired Generation 145 110 13 9 - ---------------------------------------------------- --------- ------------- ------------ ------------- Total Generation 5,317 5,783 103 103 Purchased Power 681 424 40 25 - ---------------------------------------------------- --------- ------------- ------------ ------------- Total Resources 5,998 6,207 $ 143 $ 128 ============ ============= Less Line Losses, Company Use and Other 414 395 - ---------------------------------------------------- --------- ------------- Total Energy Sold 5,584 5,812 ==================================================== ========= =============
During the first six months of 2005, planned outages at TEP's 380-megawatt coal-fired Springerville Unit 2 facility, San Juan Unit 2 and Four Corners Unit 5, the expiration of the SCE Exchange and minor unplanned outages at some of TEP's coal-fired generating units led to higher gas-related fuel costs and higher purchased power expenses. Total fuel expense at TEP's generating plants was unchanged in the first six months of 2005, compared to the same period last year. Lower coal-fired generation costs were offset by an increase in gas-related fuel expense of $4 million, due to the higher use of TEP's gas-fired generating resources as well as higher commodity prices for gas. The average price per MMBtu of gas at the Permian basin was 12% higher than in the first six months of 2004. 39 Purchased power expense increased $15 million compared with the first six months of 2004, due to an increase of 61%, or 257,000 MWh, in power purchases to replace energy lost from coal plant outages and the SCE Exchange. In addition, the average wholesale market price for power was 7% higher compared with the first six months of 2004. See Factors Affecting Results of Operations, Western Energy Markets, Market Prices, below. The table below shows the average cost per kWh for TEP's generating plants by fuel type.
THREE MONTHS SIX MONTHS ENDED JUNE 30, ENDED JUNE 30, 2005 2004 2005 2004 -cents per kWh- -cents per kWh- --------------- ------------------------- -------------------------- Coal 1.73 1.76 1.75 1.65 Gas 9.01 9.16 8.89 8.05 All fuels 1.96 1.84 1.94 1.78 --------------- ------------ ------------ ------------ -------------
OTHER OPERATING EXPENSES Other O&M expense increased $5 million in the second quarter of 2005, compared with the same period last year; and increased $5 million in the first six months of 2005 compared with the first six months of 2004, primarily due to the plant outages described above. During the first six months of 2005, TEP recorded a gain of $3 million on the sale of excess SO2 emissions allowances. Depreciation and amortization decreased $4 million in the second quarter of 2005, compared with the second quarter of 2004 primarily due to the extension of useful lives of certain generating assets at TEP in July 2004 and April 2005. Amortization of the Transition Recovery Asset (TRA) increased $2 million in the second quarter of 2005 and $3 million in the first six months of 2005. Amortization of the TRA is the result of the Settlement Agreement with the ACC, which changed the accounting method for TEP's generation operations. This item reflects the recovery, through 2008, of transition recovery assets which were previously regulatory assets of the generation business. The amount of amortization is a function of the TRA balance and total kWh consumption by TEP's distribution customers. The table below shows estimated annual TRA amortization and unamortized TRA year-end balances for 2005 through 2008.
FUTURE ESTIMATED UNAMORTIZED TRA AMORTIZATION TRA BALANCE -Millions of Dollars- ----------------------- ---------------------------- ------------------- 2005 $ 55 $ 169 2006 64 105 2007 73 32 2008 32 - ----------------------- ---------------------------- -------------------
OTHER INCOME (DEDUCTIONS) In the second quarter and first six months of 2004, TEP's Income Statement included inter-company Interest Income of $2 million and $5 million, respectively. This represented Interest Income on a promissory note TEP received from UniSource Energy in exchange for the transfer to UniSource Energy of its stock in Millennium in 1998. UniSource Energy repaid the inter-company promissory note on March 1, 2005. On UniSource Energy's Consolidated Statement of Income, this Interest Income, as well as UniSource Energy's related interest expense, was eliminated as an inter-company transaction. See Liquidity and Capital Resources, TEP Cash Flows, Inter-Company Note from UniSource Energy, below. INTEREST EXPENSE Total interest expense increased by $1 million, or 4%, in the second quarter of 2005. In May 2005, TEP entered into a new credit agreement. Upon entering the new agreement, TEP expensed $2 million of unamortized 40 issuance costs associated with the prior credit agreement. Also in May 2005, TEP repurchased and redeemed $225 million of debt and recorded a loss of $3 million related to this transaction. For the second quarter of 2005, the $5 million of expenses related to these two transactions was partially offset by the lower rates under TEP's new credit agreement and the interest savings related to the $225 million of debt that was redeemed and repurchased. In the first six months of 2005, total interest expense decreased $2 million, or 3%, compared with the same period last year. INCOME TAX EXPENSE Income tax expense decreased $6 million in the second quarter of 2005 compared with the same period in 2004, due to lower pre-tax income. In the first six months of 2005, income tax expense decreased $10 million compared with the same period in 2004, due to lower pre-tax income. FACTORS AFFECTING RESULTS OF OPERATIONS - --------------------------------------- COMPETITION The electric utility industry has undergone significant regulatory change in the last few years designed to encourage competition in the sale of electricity and related services. However, the experience in California with deregulation has caused many states, including Arizona, to re-examine the viability of retail electric deregulation. As of January 1, 2001, all of TEP's retail customers are eligible to choose an alternate energy service provider (ESP). Certain portions of the ACC's rules that enabled ESPs to compete in the retail market were invalidated by a recent Arizona Court of Appeals decision described below. Currently none of TEP's retail customers are receiving service from ESPs. TEP has met all conditions required by the ACC to facilitate electric retail competition, including ACC approval of TEP's direct access tariffs. ESPs must meet certain conditions before electricity can be sold competitively in TEP's service territory. Examples of these conditions include ACC certification of ESPs, and execution by ESPs of, and compliance with, direct access service agreements with TEP. In January 2005, an Arizona Court of Appeals decision became final in which the Court held invalid certain portions of the ACC rules on retail competition and related market pricing. Based on this decision, we expect that the ACC will address the competition rules in an administrative proceeding. We cannot predict what changes, if any, the ACC will make to the competition rules. See Rates, Recent Motion Filed with ACC, below. TEP competes against gas service suppliers and others that provide energy services. Other forms of energy technologies may provide competition to TEP's services in the future, but to date, are not financially viable alternatives for its retail customers. Self-generation by TEP's large industrial customers could also provide competition for TEP's services in the future, but has not had a significant impact to date. In the wholesale market, TEP competes with other utilities, power marketers and independent power producers in the sale of electric capacity and energy. RATES TEP'S SETTLEMENT AGREEMENT AND RETAIL ELECTRIC COMPETITION RULES In September 1999, the ACC approved the Retail Electric Competition Rules (Rules) that provided a framework for the introduction of retail electric competition in Arizona. In November 1999, the ACC approved the Settlement Agreement between TEP and certain customer groups related to the implementation of retail electric competition in Arizona. The Rules and the Settlement Agreement established: o a period, November 1999 through 2008, for TEP to transition its generation assets from a cost of service based rate structure to a market, or competitive, rate structure; o the recovery through rates during the transition period of $450 million of stranded generation costs through a fixed competitive transition charge (fixed CTC); o capped rates for TEP retail customers through 2008; o an ACC interim review of TEP retail rates in 2004; 41 o unbundling of electric services with separate rates or prices for generation, transmission, distribution, metering, meter reading, billing and collection, and ancillary services; o a process for ESPs to become licensed by the ACC to sell generation services at market prices to TEP retail customers; o access for TEP retail customers to buy market priced generation services from ESPs beginning in 2000 (currently, no TEP customers are purchasing generation services from ESPs); o transmission and distribution services would remain subject to regulation on a cost of service basis; and o beginning in 2009, TEP's generation would be market based and its retail customers would pay the market rate for generation services. 2004 General Rate Case Information ---------------------------------- On June 1, 2004, as required by the Settlement Agreement, TEP filed general rate case information with the ACC. TEP's filing does not propose any change in retail rates, and under the terms of the Settlement Agreement, no rate case filed by TEP through 2008 may result in a net rate increase. However, absent the restriction on raising rates, TEP believes that the data in its filing would justify an increase in retail rates of 16%. The general rate case information uses a historical test year ended December 31, 2003 and establishes, based on TEP's standard offer service, that TEP is experiencing a revenue deficiency of $111 million. The rate case information includes, among other things, Springerville Unit 1 costs and other generation costs including fuel costs in excess of those recovered through existing rates. The proposed weighted cost of capital for the test year ended December 31, 2003 is 8.78%, including an 11.5% return on equity (increased from 10.67% currently authorized). The rate case information uses a hypothetical 40% equity capitalization (excluding capital lease obligations) rather than the hypothetical 37.5% equity capitalization used in TEP's last general rate case. As a result of the debt repurchases and redemptions made during the second quarter of 2005, TEP's actual equity capitalization at June 30, 2005 improved to 40.6%. On June 24, 2005, intervenor testimony in TEP's 2004 rate review was due and several intervenors filed their respective testimony. None of the intervenor testimony filed proposed any increase or decrease to TEP's rates; all intervenors recommended that TEP's rates remained unchanged. On July 11, 2005, an ACC administrative law judge (ALJ) issued a procedural order suspending the remaining testimony filing deadlines and hearing in the 2004 rate review. The order indicated that the ALJ will evaluate the parties' positions and the need for further proceedings. Despite TEP's position that it has a revenue deficiency and the intervenor testimony recommending no change in rates, the ACC could conclude during this 2004 rate review process that TEP should decrease rates; any such determination would be strongly opposed by TEP. Transition ---------- The Settlement Agreement provides that TEP's fixed CTC will expire when TEP's $450 million transition asset is fully amortized and recovered or on December 31, 2008, whichever is earlier. Based on current projections of retail sales, the TRA is expected to be fully amortized by mid-2008. The Settlement Agreement also specifies that TEP's floating competitive transition charge (floating CTC) will expire on December 31, 2008. This charge, which moves inversely to changes in market-based generation services rates, presently appears as a credit on retail customer bills. Based on current forward pricing in the wholesale energy markets, TEP anticipates that the floating CTC will continue to appear as a credit on retail customer bills through 2008. After the expiration of the floating CTC, TEP's rates for generation services should be market based. Absent any other change to TEP's retail rate structure, including continued inability to recover actual costs, TEP estimates that the expiration of the fixed CTC in 2008 (which has provided revenues, on average of .93 cents per kWh sold, or approximately $80 million annually) would result in an average decrease in revenues from retail rates of approximately 12% relative to revenues from current retail rates. However, absent any other change except the expiration of the fixed CTC, the expiration in 2008 of the floating CTC would result in market-based generation services rates which would, based on current pricing in the wholesale energy markets, produce a retail rate increase in January 2009 of approximately 10-15% relative to current retail rates. We are operating pursuant to the Settlement Agreement. However, we cannot predict the future rate methodologies for TEP which the ACC could authorize, including whether the ACC will permit or require market-based rates for generation services, reinstate cost of service ratemaking for all or a portion of TEP's generation 42 services or require an alternate methodology to determine rates for TEP's generation services. Under any circumstances, TEP will seek appropriate recovery and return on its investment in assets used to serve its customers. In the event that the ACC reinstates cost of service ratemaking for TEP's generation services and does not allow other factors that have changed in the intervening years to be considered, significant retail rate decreases could occur. TEP expects that, in establishing future rates, TEP and the ACC will review the entirety of the retail rate structure rather than focusing solely on any one of the elements noted above. Although TEP is unable to predict the type and level of future retail rates, TEP believes that the 2004 general rate case information filed with the ACC evidences that there have been a number of factors that have changed since the Settlement Agreement was approved that justify increasing or maintaining retail rates at current levels. Recent Motion Filed with ACC ---------------------------- Given the recent court action described above, the ACC may revise its Rules and rate methodologies prior to the expiration in 2008 of the Settlement Agreement. A new structure could replace that established pursuant to the Settlement Agreement prior to January 2009. In an effort to resolve the uncertainty surrounding the methodology that will be applied to determine TEP's rates for generation service after the current CTCs expire, TEP filed a motion with the ACC on May 4, 2005 requesting that the ACC issue an order declaring its position regarding the rate treatment that will be afforded to TEP's generation assets after 2008. The motion states TEP's preference for the ACC to adhere to the Settlement Agreement and continue to authorize TEP to charge market-based rates for generation services after December 31, 2008. The motion also states that, if the ACC intends to rescind TEP's authorization to charge market-based rates for its generation services, that change will have immediate consequences for the Settlement Agreement, the 2004 general rate case information filing and future TEP rate cases. Accordingly, TEP requested that the ACC clarify its intentions in this regard. In addition, TEP requested that a procedural conference be held in the 2004 rate review proceedings to discuss the status of that case pending the issuance of an order in response to TEP's motion. In May 2005, a number of participants in TEP's rate proceedings, including the Staff of the ACC, filed responses to TEP's motion. Those responses reflect differing interpretations of the Settlement Agreement which established TEP's existing rate structure and generation service rates, and the effect of the 2002 Track A order which eliminated the requirement that TEP transfer its generation assets to a subsidiary and the future of electric competition in Arizona. A number of these responses dispute TEP's assertion that the existing rate structure contemplates market-based rates for generation services after December 31, 2008. On June 1, 2005, TEP filed a reply in support of its motion. The reply stated that the differences of opinion expressed in the various responses filed underscore the need for the ACC to clarify how it will determine TEP's rates for generation services after December 31, 2008. TEP's reply also stated that, although it would prefer that the ACC continue to authorize TEP to charge market-based rates for generation services after December 31, 2008, it is concerned that its customers will be subject to a significant rate increase in 2009. TEP believes that any actions by the ACC should not deny TEP the economic benefits of the Settlement Agreement, and accordingly analyzed how the Settlement Agreement can be modified so as to: (i) preserve the intent of the parties; (ii) avoid a significant rate increase in 2009; (iii) mitigate a negative financial impact on TEP; and (iv) provide all interested parties with certainty in the near future about TEP's post-2008 rate structure. TEP's reply suggests that these goals can be accomplished through a modification to the Settlement Agreement which includes the following concepts: (i) an extension of the existing rate freeze at current rates; (ii) retention of the current CTC amortization schedule; (iii) a commitment not to seek rate treatment for certain TEP generation assets; and (iv) implementation of a mechanism to protect TEP from extreme fuel market volatility after December 31, 2008. TEP intends to discuss its proposal with the parties to the Settlement Agreement and ACC staff and, thereafter, enter into formal negotiations to seek to modify the Settlement Agreement. On June 10, 2005 and on July 11, 2005, the ALJ issued procedural orders related to TEP's 2004 rate review. The procedural orders took no action on TEP's May 4, 2005 motion, however suggested a more appropriate procedure was for TEP to file a motion to reopen the record approving the Settlement Agreement. On July 25, 2005, TEP informed the ALJ that it will file a motion by September 12, 2005, seeking to amend the 43 decision approving the Settlement Agreement to address TEP's concerns about how rates will be set after December 31, 2008. WESTERN ENERGY MARKETS As a participant in the western U.S. wholesale power markets, TEP is directly and indirectly affected by changes in market conditions and market participants. TEP competes with other utilities, power marketers and independent power producers in the sale of electric capacity and energy at market-based rates in the wholesale market. As of June 30, 2005, electric generating capacity in Arizona has grown to approximately 25,000 MW; an increase of nearly 60% since 2001. A majority of the growth over the last three years is the result of 16 new or upgraded gas-fired generating units with a combined capacity of approximately 9,200 MW. MARKET PRICES The average market price for around-the-clock energy based on the Dow Jones Palo Verde Index increased in the second quarter 2005, as did the average price for natural gas based on the Permian Index. Average market prices for around-the-clock energy began to rise in 2003 and have continued to increase during 2004 and the first six months of 2005 primarily due to high natural gas prices. As a result of all of these factors, TEP's natural gas and purchased power expenses were higher in the first six months of 2005 than the same period in 2004. Energy prices remain at these high levels to date; however, we cannot predict whether these higher prices will continue, or whether changes in various factors that influence demand and supply will cause prices to fall during 2005.
AVERAGE MARKET PRICE FOR AROUND-THE-CLOCK ENERGY $/MWH ---------------------------------------------------------- ---------------- Quarter ended June 30, 2005 $ 45 Quarter ended June 30, 2004 44 Six Months Ended June 30, 2005 $ 45 Six Months Ended June 30, 2004 42 ---------------------------------------------------------- ---------------- AVERAGE MARKET PRICE FOR NATURAL GAS $/MMBTU ---------------------------------------------------------- ---------------- Quarter ended June 30, 2005 $6.10 Quarter ended June 30, 2004 5.39 Six Months Ended June 30, 2005 $ 5.83 Six Months Ended June 30, 2004 5.21 ---------------------------------------------------------- ----------------
In addition to energy from its coal-fired facilities, TEP typically uses purchased power, supplemented by generation from its gas-fired units, to meet the summer peak demands of its retail customers and to meet local reliability needs. Some of these purchased power contracts are price indexed to natural gas prices. Short-term and spot power purchase prices are also closely correlated to natural gas prices. Due to its increasing seasonal gas and purchased power usage, TEP hedges a portion of its total natural gas exposure from plant fuel and gas-indexed purchased power with fixed price contracts for a maximum of three years. TEP currently has approximately 60% of this exposure hedged for the remaining portion (July through October) of the summer peak period of 2005 at a weighted average price of $5.88 per MMBtu. TEP purchases its remaining gas fuel needs and purchased power in the spot and short-term markets. We expect the market price and demand for capacity and energy to continue to be influenced by factors including: o weather; o continued population growth in the western U.S.; o economic conditions in the western U.S.; o availability of generating capacity throughout the western U.S.; o the extent of electric utility industry restructuring in Arizona, California and other western states; o the effect of FERC regulation of wholesale energy markets; o the availability and price of natural gas; o availability of hydropower; 44 o transmission constraints; and o environmental regulations and the cost of compliance. WATER SUPPLY Drought conditions in northern New Mexico and Colorado, combined with increased water usage in Arizona, Nevada and southern California, have caused water levels to significantly recede at Lake Powell, which supplies operating water for the Navajo Generating Station. The decision was made in the second quarter of 2005 to lower the water intakes in Lake Powell, which will help minimize the exposure of water loss to the plant due to continuing drought conditions. TEP's share of the expected total cost is approximately $2 million based on its 7.5% ownership interest in Navajo Units 1, 2, and 3 (168 MW capacity). TEP does not believe that its operations will be materially affected by this drought. EMISSIONS ALLOWANCES TEP has SO2 Emissions Allowances in excess of what is required to operate its generating units. The excess results primarily from a higher removal rate of SO2 emissions at Springerville Units 1 and 2 following recent upgrades to environmental plant components and related changes to plant operations. From time to time, TEP will sell a portion of its excess Emissions Allowances. In the first six months of 2005, TEP sold 5,000 SO2 Emissions Allowances, recognizing a gain of $3 million. As of June 30, 2005, TEP has sold forward 2,500, 10,000 and 7,500 SO2 Emissions Allowances for settlement in 2005 (third quarter), 2006 and 2007, respectively. LIQUIDITY AND CAPITAL RESOURCES - ------------------------------- TEP CASH FLOWS TEP's capital requirements consist primarily of capital expenditures and optional and mandatory redemptions of long-term debt and capital lease obligations. Cash flow from operations typically is the lowest in the first quarter and highest in the third quarter due to TEP's summer peaking load.
SIX MONTHS ENDED JUNE 30, 2005 2004 -Millions of Dollars- - ---------------------------------------------------------------- --------------- -------------- Net Cash Flows - Operating Activities $ 74 $ 119 Capital Expenditures (68) (53) - ---------------------------------------------------------------- --------------- -------------- Net Cash Flows after Capital Expenditures* 6 66 - ---------------------------------------------------------------- --------------- -------------- Debt Maturities - (1) Retirement of Capital Lease Obligations (49) (44) Proceeds from Investment in Springerville Lease Debt and Equity 8 8 - ---------------------------------------------------------------- --------------- -------------- Net Cash Flows Available after Required Payments* $ (35) $ 29 ================================================================ =============== ============== * We believe that Net Cash Flows after Capital Expenditures and Net Cash Flows Available After Required Payments, which are non-GAAP financial measures, provide useful information to investors as measures of liquidity and our ability to meet our capital requirements and mandatory redemptions of debt and capital lease obligations.
During 2005, TEP expects to generate sufficient internal cash flows to fund its operating activities, construction expenditures, required debt maturities, and to pay dividends to UniSource Energy. However, TEP's cash flows may vary due to changes in wholesale revenues, changes in short-term interest rates, and other factors. TEP currently has $50 million available under its Revolving Credit Facility which it may borrow if cash flows fall short of expectations or if monthly cash requirements temporarily exceed available cash balances. As of June 30, 2005, TEP had $40 million outstanding under its Revolving Credit Facility, of which $30 million was repaid in July 2005. See UniSource Energy, Liquidity and Capital Resources, UniSource Energy Credit Agreement, Use of Proceeds, above, and Bond Issuances and Redemptions, below. 45 OPERATING ACTIVITIES In the first six months of 2005, net cash flows from operating activities declined by $45 million compared with the same period in 2004. The following factors contributed to the decrease: 2005 included: o a $5 million increase in cash receipts from electric retail sales was offset by a $4 million decrease in cash receipts from wholesale sales due to the lower availability of excess power to sell into the wholesale market; o a $23 million increase in fuel and purchased power costs paid, due to higher replacement power costs resulting from planned coal plant maintenance outages, lost energy from the expiration of the SCE Exchange in May 2005 and higher gas-related fuel costs. o a $13 million increase in payments for O&M costs related to the planned outage at Springerville Unit 2 and maintenance costs at the San Juan Generating Station; O&M costs include $3 million in cash receipts from the sale of SO2 Emissions Allowances; o a $5 million increase in wages paid due to a greater number of employees, rising wage levels and higher incentive compensation; o an $11 million increase in interest received, due primarily to interest received from UniSource Energy when it repaid its $95 million inter-company loan to TEP; and o a $2 million decrease in total interest paid due to lower capital lease obligation balances, lower long-term debt balances and lower annual fees under TEP's Credit Agreement that was entered into in May 2005. 2004 included: o the return of a $17 million deposit related to TEP's second mortgage indenture. INVESTING ACTIVITIES Net cash used for investing activities was $3 million higher in the first six months of 2005 compared with the same period in 2004, due to the following: 2005 included: o a $15 million increase in capital expenditures related to a planned maintenance outage at Springerville and TEP's share of the construction costs of the Luna Energy Facility; and o other cash receipts of $7 million related to proceeds received from the redemption of a certificate of deposit and the sale of land by a TEP subsidiary. 2004 included: o the use of $4 million to invest in Springerville lease debt. FINANCING ACTIVITIES Net cash used for financing activities was $35 million higher in the first six months of 2005 compared with the same period in 2004. The following factors contributed to the increase: 2005 included: 46 o a $281 million increase in repayments on long-term debt related to TEP's early redemption of $53 million of First Mortgage Bonds in the first three months of 2005, and the repurchase and redemption of $225 million of fixed-rate tax exempt debt in May 2005; o a $6 million increase in other financing costs related to reimbursement of merger expenses paid by UniSource Energy on behalf of TEP; o a $5 million increase in scheduled payments made on capital lease obligations; o a capital contribution of $110 million from UniSource Energy; o the receipt of $95 million from UniSource Energy as a repayment for an inter-company loan; o $40 million borrowed under TEP's revolving credit facility; and o a $4 million decrease in debt issuance/retirement costs. 2004 included: o $7 million of dividends paid to UniSource Energy. At June 30, 2005, there were $40 million of outstanding borrowings under TEP's revolving credit facility. TEP repaid $30 million of these amounts in July 2005. As of August 4, 2005, cash and cash equivalents available to TEP was approximately $42 million. Capital Contribution from UniSource Energy ------------------------------------------ On May 10, 2005, UniSource Energy made a $110 million capital contribution to TEP. TEP used the proceeds during May 2005 to redeem or repurchase certain of its existing debt through tender offers and redemptions. See Bond Issuance and Redemptions, below. Bond Repurchases and Redemptions -------------------------------- TEP made a sinking fund payment of $1 million on its 6.1% 1941 Mortgage IDBs in January 2005. In March 2005, TEP redeemed at par the remaining $31 million of its 6.1% 1941 Mortgage IDBs due in 2008, as well as the remaining $21 million of its 7.5% 1941 Mortgage IDBs due in 2006. On May 11, 2005, TEP purchased $147 million of its 1997 Pima Series B and $74 million of its 1997 Pima Series C fixed-rate tax-exempt bonds (Repurchased Bonds) at a price of $101.50 per $100 principal amount. On May 18, 2005, TEP redeemed at par the remaining $4 million of bonds outstanding under those series. TEP does not currently plan on canceling the Repurchased Bonds, which will remain outstanding under their respective indentures; however, the Repurchased Bonds will not be presented in our financial statements. TEP may choose to resell the Repurchased Bonds to third parties or cancel them in the future. As a result of the capital contribution, inter-company note repayment, and the bond repurchases and redemptions, TEP's ratio of equity to total capitalization (excluding capital leases) improved to 40.6% as of June 30, 2005, which allows TEP to dividend up to 100% of its current year net income to UniSource Energy. 47 Capital Lease Obligations ------------------------- At June 30, 2005, TEP had $716 million of total capital lease obligations on its balance sheet. The table below provides a summary of the outstanding lease amounts.
BALANCE AT LEASED ASSET JUNE 30, 2005 EXPIRATION ----------------------------------------------- --------------------------- --------------------- - In Millions - Springerville Unit 1 $432 2014 Springerville Coal Handling Facilities 126 2015 Springerville Common Facilities 104 2020 Sundt Unit 4 54 2011 Other Leases - 2006 ----------------------------------------------- --------------------------- Total Capital Lease Obligations $716 =============================================== ===========================
Except for TEP's 13% equity interest in the Springerville Coal Handling Facilities, TEP will not own these assets at the expiration of the leases. TEP may renew the leases or purchase the leased assets at such time. The renewal and purchase options for Springerville Unit 1 and Sundt Unit 4 are generally for fair market value as determined at that time, while the purchase price option is fixed for the Springerville Coal Handing Facilities and Common Facilities. TEP Credit Agreement -------------------- On May 4, 2005, TEP entered into a new $401 million Credit Agreement (TEP Credit Agreement) to replace its previous $401 million credit agreement. The TEP Credit Agreement includes a $60 million revolving credit facility and a $341 million letter of credit facility to support $329 million of tax-exempt variable rate bonds. The TEP Credit Agreement expires May 4, 2010 and is secured by $401 million of Mortgage Bonds. The TEP Credit Agreement restricts additional indebtedness, liens, sale of assets and sale-leasebacks agreements. The TEP Credit Agreement also requires TEP to meet a minimum cash coverage ratio and a maximum leverage ratio. If TEP complies with the terms of the TEP Credit Agreement, TEP may pay dividends to UniSource Energy. Certain regulatory actions may cause a decrease in the amount that may be borrowed. As of June 30, 2005, TEP was in compliance with the terms of the TEP Credit Agreement. If an event of default occurs, the TEP Credit Agreement may become immediately due and payable. An event of default includes failure to make required payments under the TEP Credit Agreement; change in control, as defined; failure of TEP or certain subsidiaries to make payments or default on debt greater than $20 million; or certain bankruptcy events at TEP or certain subsidiaries. Interest rates and fees under the TEP Credit Agreement are based on a pricing grid tied to TEP's credit ratings. Letter of credit fees are 0.875% per annum and amounts drawn under a letter of credit would bear interest at LIBOR plus 0.875% per annum. TEP pays interest on borrowings under the revolving credit facility at LIBOR plus 0.875% or at the agent bank's reference rate. TEP also pays a commitment fee of 0.20% on the unused portion of the revolving credit facility. As of June 30, 2005, TEP had $40 million outstanding under its Revolving Credit Facility. On May 10, 2005, TEP borrowed $25 million under its Revolving Credit Facility in connection with the redemption of $225 million of fixed-rate tax-exempt debt. TEP borrowed an additional $15 million on June 30, 2005, to help pay its semi-annual capital lease obligations. At August 4, 2005, TEP had $10 million outstanding under its revolving credit facility. See UniSource Energy, Liquidity and Capital Resources, UniSource Energy Credit Agreement, Use of Proceeds, above, and Bond Repurchases and Redemptions, above. Mortgage Indentures ------------------- On June 10, 2005, TEP terminated its 1941 Mortgage (formerly known as its First Mortgage). TEP's remaining mortgage is its 1992 Mortgage (formerly known as its Second Mortgage). TEP's Credit Agreement limits the amount of mortgage bonds that may be outstanding to no more than $650 million. At June 30, 2005, TEP had a total of $539 million in outstanding mortgage bonds. Although the 48 1992 Mortgage would allow TEP to issue additional bonds, the limit imposed by the TEP Credit Agreement is more restrictive and is currently the governing limitation. CONTRACTUAL OBLIGATIONS There have been no significant changes in TEP's contractual obligations or other commercial commitments from those reported in TEP's 2004 Annual Report on Form 10-K, other than those reported above in Bond Repurchases and Redemption, TEP Credit Agreement and Mortgage Indentures. DIVIDENDS ON COMMON STOCK TEP can pay dividends if it maintains compliance with the TEP Credit Agreement and certain financial covenants. As of June 30, 2005, TEP was in compliance with the terms of the TEP Credit Agreement. The ACC Holding Company Order, as modified by the UES Settlement Agreement, restricted the amount of dividends that TEP may pay to UniSource Energy. Until TEP's ratio of common equity to total capitalization (excluding capital lease obligations) equaled 40%, TEP could not pay dividends in excess of 75% of its net income. As of June 30, 2005, TEP's ratio of common equity to total capitalization (excluding capital lease obligations) was 40.6%. The Federal Power Act states that dividends shall not be paid out of funds properly included in capital accounts. Although the terms of the Federal Power Act are unclear, we believe that there is a reasonable basis to pay dividends from current year earnings. UNS GAS RESULTS OF OPERATIONS - --------------------- SECOND QUARTER 2005 RESULTS UNS Gas reported net income of less than $1 million in the second quarter of 2005, compared with a net loss of $1 million in the second quarter of 2004. As of June 30, 2005, UNS Gas had approximately 135,870 retail customers, a 4% increase from last year. The table below shows UNS Gas' therm sales and revenues for the second quarters of 2005 and 2004.
SALES REVENUE THREE MONTHS ENDED JUNE 30, 2005 2004 2005 2004 ------------------------------------------- ---------------------------------- -------------------------------- - Millions of Therms - - Millions of Dollars - RETAIL THERM SALES: Residential 11 8 $ 13 $ 11 Commercial 6 4 6 4 Industrial 1 1 1 1 Public Authorities 1 1 1 1 ------------------------------------------- ----------------- ---------------- ----------------- -------------- TOTAL RETAIL THERM SALES 19 14 21 17 Transport - - 1 1 Negotiated Sales Program (NSP) 7 4 4 2 ------------------------------------------- ----------------- ---------------- ----------------- -------------- TOTAL THERM SALES 26 18 $ 26 $ 20 =========================================== ================= ================ ================= ==============
Retail therm sales were 36% higher in the second quarter of 2005 compared with the same period last year due to customer growth and cooler weather. Retail revenues increased $4 million compared with the second quarter of 2004. Through a Negotiated Sales Program (NSP) approved by the ACC, UNS Gas supplies natural gas to some of its large transportation customers. Approximately one half of the margin earned on these NSP sales is retained by UNS Gas, while the remainder benefits retail customers through a credit to the Purchased Gas 49 Adjustor (PGA) mechanism which reduces the gas commodity price. See Factors Affecting Results of Operations, Rates and Regulation, Energy Cost Adjustment Mechanism, below. The table below provides summary financial information for UNS Gas.
THREE MONTHS ENDED JUNE 30, 2005 2004 -------------------------------------------------------- --------------------------- - Millions of Dollars - Gas Revenues $ 26 $ 20 Other Revenues 1 1 -------------------------------------------------------- ------------ -------------- Total Operating Revenues 27 21 -------------------------------------------------------- ------------ -------------- Purchased Gas Expense 17 16 Other Operations and Maintenance Expense 5 3 Depreciation and Amortization 2 1 Taxes other than Income Taxes 1 1 -------------------------------------------------------- ------------ -------------- Total Other Operating Expenses 25 21 -------------------------------------------------------- ------------ -------------- Operating Income 2 - -------------------------------------------------------- ------------ -------------- Total Interest Expense 2 2 Income Tax Expense (Benefit) - (1) -------------------------------------------------------- ------------ -------------- NET INCOME $ - $ (1) ======================================================== ============ ==============
YEAR-TO-DATE JUNE 30, 2005 RESULTS UNS Gas reported net income of $4 million in the first six months of 2005, compared with $3 million in the same period last year. The table below shows UNS Gas' therm sales and revenues for the first six months ended June 30, 2005 and 2004.
SALES REVENUE SIX MONTHS ENDED JUNE 30, 2005 2004 2005 2004 ------------------------------------------- ---------------------------------- -------------------------------- - Millions of Therms - - Millions of Dollars - RETAIL THERM SALES: Residential 41 39 $ 44 $ 43 Commercial 16 15 15 14 Industrial 2 2 1 1 Public Authorities 4 4 3 4 ------------------------------------------- ----------------- ---------------- ----------------- -------------- TOTAL RETAIL THERM SALES 63 60 63 62 Transport - - 2 1 Negotiated Sales Program (NSP) 12 11 8 6 ------------------------------------------- ----------------- ---------------- ----------------- -------------- TOTAL THERM SALES 75 71 $ 73 $ 69 =========================================== ================= ================ ================= ==============
Retail therm sales were 6% higher in the first six months of 2005 compared with the same period last year due primarily to customer growth. Retail revenues increased $1 million in the first six months of 2005. 50 The table below provides summary financial information for UNS Gas.
SIX MONTHS ENDED JUNE 30, 2005 2004 -------------------------------------------------------- --------------------------- - Millions of Dollars - Gas Revenues $ 73 $ 69 Other Revenues 1 1 -------------------------------------------------------- ------------ -------------- Total Operating Revenues 74 70 -------------------------------------------------------- ------------ -------------- Purchased Gas Expense 48 45 Other Operations and Maintenance Expense 11 11 Depreciation and Amortization 3 3 Taxes other than Income Taxes 2 2 -------------------------------------------------------- ------------ -------------- Total Other Operating Expenses 64 61 -------------------------------------------------------- ------------ -------------- Operating Income 10 9 -------------------------------------------------------- ------------ -------------- Total Interest Expense 3 3 Income Tax Expense 3 3 -------------------------------------------------------- ------------ -------------- NET INCOME $ 4 $ 3 ======================================================== ============ ==============
FACTORS AFFECTING RESULTS OF OPERATIONS - --------------------------------------- RATES AND REGULATION ENERGY COST ADJUSTMENT MECHANISM UNS Gas' retail rates include a PGA mechanism intended to address the volatility of natural gas prices and allows UNS Gas to recover its costs through a price adjustor. The PGA charge changes monthly based on an ACC approved mechanism that compares the twelve-month rolling average gas cost to the base cost of gas, subject to limitations on how much the price per therm may change in a twelve month period. The difference between the actual cost of UNS Gas' gas supplies and transportation contracts and that currently allowed by the ACC are deferred and recovered or repaid through the PGA mechanism. When under or over recovery trigger points are met, UNS Gas may request a PGA surcharge or surcredit with the goal of collecting or returning the amount deferred from or to customers over a twelve month period. In January 2005, UNS Gas requested the ACC approve a PGA surcharge of $0.06 per therm beginning April 1, 2005 and removed one year later, to recover its excess gas purchase costs. The previous PGA surcharge of $0.1155 per therm took effect October 1, 2003 and ended November 1, 2004. On March 31, 2005, the ACC approved a PGA surcharge of $0.03 per therm beginning April 11, 2005 until the excess gas purchase costs are fully recovered. Based on current and projected gas prices and the rates currently in effect, we expect the PGA balance to increase. Given the gas price projections and expected pipeline transportation cost increases, UNS Gas may be required to request an increase in this surcharge. LIQUIDITY AND CAPITAL RESOURCES - ------------------------------- UNS Gas' capital requirements consist primarily of capital expenditures. In the first six months of 2005, capital expenditures were $13 million. During 2005, UNS Gas expects to generate sufficient internal cash flows to fund its operating activities and a portion of its construction expenditures. UNS Gas will meet its remaining cash needs through a combination of capital contributions from UniSource Energy and borrowings under a revolving credit facility that was established in April 2005. See UNS Gas/UNS Electric Revolver, below. In January 2005, UNS Gas established a short-term inter-company promissory note to UniSource Energy, by which it may borrow up to $10 million for general corporate purposes. On March 10, 2005, UniSource Energy contributed an additional $6 million in capital to UNS Gas. UNS Gas used the proceeds of this contribution to repay the $6 million outstanding on the inter-company promissory note. 51 The table below provides summary information for operating cash flow and capital expenditures for the first six months of 2005 and 2004.
SIX MONTHS ENDED JUNE 30, 2005 2004 -------------------------------------------- ------------------------------ - Millions of Dollars - Net Cash Flows - Operating Activities $14 $ 20 Capital Expenditures 13 9 -------------------------------------------- ---------------- -------------
UNS Gas/UNS Electric Revolver ----------------------------- In April 2005, UNS Gas and UNS Electric entered into a $40 million three-year unsecured revolving credit agreement due April 15, 2008, with a group of lenders (the UNS Gas/UNS Electric Revolver). Either borrower may borrow up to a maximum of $30 million; however, the total combined amount borrowed cannot exceed $40 million. UNS Gas and UNS Electric intend to use the proceeds of any loans or letters of credit for general corporate purposes. UNS Gas is only liable for UNS Gas' borrowings, and similarly, UNS Electric is only liable for UNS Electric's borrowings under the UNS Electric/UNS Gas Revolver. UES guarantees the obligations of both UNS Gas and UNS Electric. The borrowers pay interest at LIBOR plus 1.50% or at the agent bank's reference rate plus 0.50%. UNS Gas and UNS Electric also pay a commitment fee of 0.45% on the unused portion of the revolving credit facility. The UNS Gas/UNS Electric Revolver contains restrictions on additional indebtedness, liens, mergers and sales of assets. The UNS Gas/UNS Electric Revolver also contains a maximum leverage ratio and a minimum cash flow to interest coverage ratio for each borrower. As of June 30, 2005, UNS Gas and UNS Electric were each in compliance with the terms of the UNS Gas/UNS Electric Revolver. If an event of default occurs, the UNS Gas/UNS Electric Revolver may become immediately due and payable. An event of default includes failure to make required payments under the UNS Gas/UNS Electric Revolver; certain change in control transactions, certain bankruptcy events of UNS Gas or UNS Electric, or failure of UES, UNS Gas or UNS Electric to make payments or default on debt greater than $4 million. UNS Gas and UNS Electric expect to draw upon the UNS Gas/UNS Electric Revolver from time to time for seasonal working capital purposes and to fund a portion of capital expenditures. As of June 30, 2005, UNS Gas and UNS Electric had no borrowings outstanding under the UNS Gas/UNS Electric Revolver. Senior Unsecured Notes ---------------------- UNS Gas has $100 million of senior unsecured notes outstanding that are guaranteed by UES. The note purchase agreement for UNS Gas restricts transactions with affiliates, mergers, liens, restricted payments, and incurrence of indebtedness, and also contains a minimum net worth test. As of June 30, 2005, UNS Gas was in compliance with the terms of its note purchase agreement. UNS Gas must meet a leverage test and an interest coverage test in order to issue additional debt or pay dividends. However, UNS Gas may, without meeting these tests, refinance existing debt and incur up to $7 million in short-term debt. DIVIDENDS ON COMMON STOCK The ACC limits dividend payments by UNS Gas to 75% of earnings, until the ratio of UNS Gas' common equity to total capitalization reaches 40%. In March 2005, UniSource Energy made a capital contribution of $6 million to UNS Gas. At June 30, 2005, the ratio of common equity to total capitalization for UNS Gas was 41%. The note purchase agreement for UNS Gas contains restrictions on dividends. UNS Gas may pay dividends so long as (a) no default or event of default exists and (b) it could incur additional debt under the debt incurrence test. See Senior Unsecured Notes, above. It is unlikely, however, that UNS Gas will pay dividends in the next five years due to expected cash requirements for capital expenditures. 52 UNS ELECTRIC RESULTS OF OPERATIONS - --------------------- SECOND QUARTER 2005 RESULTS UNS Electric reported net income of $1 million in the second quarters of 2005 and 2004. Similar to TEP's operations, we expect UNS Electric's operations to be seasonal in nature, with peak energy demand occurring in the summer months. As of June 30, 2005, UNS Electric had approximately 87,461 retail customers, a 5% increase from last year. The table below shows UNS Electric's kWh sales and revenues for the second quarters of 2005 and 2004.
SALES REVENUE THREE MONTHS ENDED JUNE 30, 2005 2004 2005 2004 ---------------------------------------- ------------------------------------- ---------------------------------- - Millions of kWh - - Millions of Dollars - ELECTRIC RETAIL SALES: Residential 170 140 $ 17 $ 15 Commercial 156 159 16 16 Industrial 45 58 3 4 Other 1 1 - - ---------------------------------------- ----------------- ------------------- ---------------- ----------------- TOTAL ELECTRIC RETAIL SALES 372 358 $ 36 $ 35 ======================================== ================= =================== ================ =================
Retail kWh sales 4% higher in the second quarter of 2005 compared with the same period last year due to customer growth and warm weather. The table below provides summary financial information for UNS Electric.
THREE MONTHS ENDED JUNE 30, 2005 2004 -------------------------------------------------------- --------------------------- - Millions of Dollars - Electric Revenues $ 37 $ 35 Other Revenues - - -------------------------------------------------------- ------------ -------------- Total Operating Revenues 37 35 -------------------------------------------------------- ------------ -------------- Purchased Energy Expense 24 24 Other Operations and Maintenance Expense 6 5 Depreciation and Amortization 3 2 Taxes other than Income Taxes 1 1 -------------------------------------------------------- ------------ -------------- Total Other Operating Expenses 34 32 -------------------------------------------------------- ------------ -------------- Operating Income 3 3 -------------------------------------------------------- ------------ -------------- Total Interest Expense 1 1 Income Tax Expense 1 1 -------------------------------------------------------- ------------ -------------- NET INCOME $ 1 $ 1 ======================================================== ============ ==============
YEAR-TO-DATE JUNE 30, 2005 RESULTS UNS Electric reported net income of $1 million in the first six months of 2005, compared with net income of $2 million in the same period last year. The table below shows UNS Electric's kWh sales and revenues for the six months ended June 30, 2005 and 2004. 53
SALES REVENUE SIX MONTHS ENDED JUNE 30, 2005 2004 2005 2004 ---------------------------------------- ------------------------------------- ---------------------------------- - Millions of kWh - - Millions of Dollars - ELECTRIC RETAIL SALES: Residential 321 292 $ 33 $ 30 Commercial 278 280 29 29 Industrial 87 101 6 7 Other 2 2 - - ---------------------------------------- ----------------- ------------------- ---------------- ----------------- TOTAL ELECTRIC RETAIL SALES 688 675 $ 68 $ 66 ======================================== ================= =================== ================ =================
Retail kWh sales increased 2% in the first six months of 2005 compared with the same period last year, due primarily to customer growth. The table below provides summary financial information for UNS Electric.
SIX MONTHS ENDED JUNE 30, 2005 2004 ------------------------------------------------ -------------------------- - Millions of Dollars - Electric Revenues $ 68 $ 66 Other Revenues - 1 ------------------------------------------------ ------------ ------------- Total Operating Revenues 68 67 ------------------------------------------------ ------------ ------------- Purchased Energy Expense 45 45 Other Operations and Maintenance Expense 12 11 Depreciation and Amortization 5 4 Taxes other than Income Taxes 2 1 ------------------------------------------------ ------------ ------------- Total Other Operating Expenses 64 61 ------------------------------------------------ ------------ ------------- Operating Income 4 6 ------------------------------------------------ ------------ ------------- Total Interest Expense 2 2 Income Tax Expense 1 2 ------------------------------------------------ ------------ ------------- NET INCOME $ 1 $ 2 ================================================ ============ =============
FACTORS AFFECTING RESULTS OF OPERATIONS - --------------------------------------- COMPETITION As required by the ACC order approving UniSource Energy's acquisition of the Citizens' Arizona gas and electric assets, on November 3, 2003, UNS Electric filed with the ACC a plan to open its service territories to retail competition by December 31, 2003. The plan addresses all aspects of implementation. It includes UNS Electric's unbundled distribution tariffs for both standard offer customers and customers that choose competitive retail access, as well as Direct Access and Settlement Fee schedules. UNS Electric's direct access rates for both transmission and ancillary services will be based upon its FERC Open Access Transmission Tariff. The plan is subject to review and approval by the ACC. As a result of the court decisions concerning the ACC's Retail Electric Competition Rules, we are unable to predict when and how the ACC will address this plan. See Tucson Electric Power Company, Factors Affecting Results of Operations, Competition, above for information regarding the recent Arizona Court of Appeals decision. RATES AND REGULATION ENERGY COST ADJUSTMENT MECHANISM UNS Electric's retail rates include a Purchased Power and Fuel Adjustor Clause (PPFAC), which allows for a separate surcharge or surcredit to the base rate for delivered purchased power to collect or return under or 54 over recovery of costs. The ACC has approved a PPFAC surcharge of $0.01825 per kWh to recover the cost of the current full-requirements power supply agreement with PWCC. LIQUIDITY AND CAPITAL RESOURCES - ------------------------------- UNS Electric's capital requirements consist primarily of capital expenditures. In the first six months of 2005, capital expenditures were $9 million. To improve the reliability of service in Santa Cruz County, UNS Electric plans to build a 20 MW gas-fired combustion turbine as well as upgrade its existing 115 kV line. The turbine should be in place by mid-2006, helping to improve reliability while the approval and permitting process for the 345 kV Tucson to Nogales transmission line continues. UNS Electric expects its capital expenditures for the second half of 2005 to increase by approximately $8 million related to the turbine. During 2005, UNS Electric expects to generate sufficient internal cash flows to fund its operating activities and a portion of its construction expenditures. UNS Electric will meet its remaining cash needs through a combination of capital contributions from UniSource Energy and borrowings under a revolving credit facility that was established in April 2005. On March 10, 2005, UniSource Energy contributed an additional $4 million of capital to UNS Electric. The table below provides summary information for operating cash flow and capital expenditures for the first quarters of 2005 and 2004.
SIX MONTHS ENDED JUNE 30, 2005 2004 ---------------------------------------------------- ------------------------------- - Millions of Dollars - Net Cash Flows - Operating Activities $9 $ 8 Capital Expenditures 9 9 ---------------------------------------------------- ---------------- --------------
UNS Gas/UNS Electric Revolver ----------------------------- See UNS Gas, Liquidity and Capital Resources, UNS Gas/UNS Electric Revolver above for description of UNS Electric's unsecured revolving credit agreement. Senior Unsecured Notes ---------------------- UNS Electric has $60 million of senior unsecured notes outstanding that are guaranteed by UES. The note purchase agreement for UNS Electric restricts transactions with affiliates, mergers, liens, restricted payments, and incurrence of indebtedness and also contains a minimum net worth test. As of June 30, 2005, UNS Electric was in compliance with the terms of its note purchase agreement. UNS Electric must meet a leverage test and an interest coverage test to issue additional debt or to pay dividends. However, UNS Electric may, without meeting these tests, refinance existing debt and incur up to $5 million in short-term debt. DIVIDENDS ON COMMON STOCK The ACC limits dividend payments by UNS Electric to 75% of earnings, until the ratio of common equity to total capitalization reaches 40%. In March 2005, UniSource Energy made a capital contribution of $4 million to UNS Electric. At June 30, 2005, the ratio of common equity to total capitalization for UNS Electric was 43%. The note purchase agreement for UNS Electric contains restrictions on dividends. UNS Electric may pay dividends so long as (a) no default or event of default exists and (b) it could incur additional debt under the debt incurrence test. See Senior Unsecured Notes, above. It is unlikely, however, that UNS Electric will pay dividends in the next five years due to expected cash requirements for capital expenditures. 55 GLOBAL SOLAR ENERGY, INC. RESULTS OF OPERATIONS - --------------------- UniSource Energy accounts for Global Solar under the consolidation method and recognizes 100% of Global Solar's losses. Global Solar recognizes expense when funding is used for research, development and administrative costs. The table below provides a breakdown of the net losses recorded by Global Solar:
THREE MONTHS ENDED JUNE 30, 2005 2004 --------------------------------------------------------------- -------------- ------------- - Millions of Dollars - Global Solar Operating Revenues $ 1 $ 2 Research & Development Contract Expenses & Losses (1) (1) Depreciation & Amortization Expense (1) (1) Administrative & Other Costs (2) (2) Income Tax Benefits 1 1 --------------------------------------------------------------- -------------- ------------- Total Global Solar Net Loss $ (2) $ (1) =============================================================== ============== ============= SIX MONTHS ENDED JUNE 30, 2005 2004 --------------------------------------------------------------- -------------- ------------- - Millions of Dollars - Global Solar Operating Revenues $ 2 $ 3 Research & Development Contract Expenses & Losses (1) (2) Depreciation & Amortization Expense (2) (1) Administrative & Other Costs (4) (4) Income Tax Benefits 2 2 --------------------------------------------------------------- -------------- ------------- Total Global Solar Net Loss $ (3) $ (2) =============================================================== ============== =============
GLOBAL SOLAR COMMITMENTS UniSource Energy intends to cease additional funding of Global Solar. To that end, Millennium plans to seek additional investors for Global Solar, or sell all or part of its interest, or a combination of both, to preserve the value of Global Solar. We anticipate that any operating and capital funding required to maintain Global Solar in the interim will be provided only out of existing Millennium cash or cash returns from other Millennium investments. We believe such cash and returns will be adequate for that purpose and to fund Millennium's remaining commitments to Global Solar. In February 2005, Millennium was authorized to fund up to an additional $5 million for capital expenditures and operations at Global Solar. Millennium funded $3 million of this commitment during the first six months of 2005. Global Solar has $1 million in commitments to incur future expenses related to government contracts. OTHER RESULTS OF OPERATIONS - --------------------- Other non-reportable segments consist of UniSource Energy parent company expenses, which includes interest expense (net of tax) related to the UniSource Energy Convertible Senior Notes, the UniSource Credit Agreement, a note payable from UniSource Energy to TEP; income and losses from Millennium investments other than Global Solar, and income and losses from UED. The note payable from UniSource Energy to TEP was repaid in March 2005. 56 The table below summarizes the income and losses for the Other non-reportable segments:
THREE MONTHS ENDED JUNE 30, 2005 2004 ------------------------------------------------------------------------------------ -------------- --------------- - Millions of Dollars - Other Millennium Investments $ - $ (2) UniSource Energy Development Company - (1) UniSource Energy Parent Company (2) (1) ------------------------------------------------------------------------------------ -------------- --------------- Total Other $ (2) $ (4) ==================================================================================== ============== =============== SIX MONTHS ENDED JUNE 30, 2005 2004 ------------------------------------------------------------------------------------ -------------- --------------- - Millions of Dollars - Other Millennium Investments $ (1) $ 1 UniSource Energy Development Company - (1) UniSource Energy Parent Company (2) (3) ------------------------------------------------------------------------------------ -------------- --------------- Total Other $ (3) $ (3) ==================================================================================== ============== ===============
OTHER MILLENNIUM INVESTMENTS Millennium accounts for its investments under the consolidation method and the equity method. In some cases, Millennium is an investment's sole provider of funding. When this is the case, Millennium recognizes 100% of an investment's losses, because as sole provider of funds it bears all of the financial risk. To the extent that an investment becomes profitable and Millennium has recognized losses in excess of its percentage ownership, Millennium will recognize 100% of an investment's net income until Millennium's recognized losses equal its ownership percentage of losses. Results from Other Millennium Investments for the three months ended June 30, 2005 include after-tax losses of less than $1 million each from several of Millennium's other investments. Results from Other Millennium Investments for the three months ended June 30, 2004 include after-tax gains of $3 million from Haddington and $1 million from MicroSat. These gains were partially offset by after-tax losses of less than $1 million each from several of Millennium's other investments. CONSOLIDATED MILLENNIUM INVESTMENTS AND COMMITMENTS In 2004, Millennium funded $1.5 million and Dow Corning Enterprises, Inc. (DCEI) funded $1 million in debt commitments to Infinite Power Solutions, Inc. (IPS). In April 2005, Millennium and DCEI entered into a transaction with third parties that included the formation of a new Delaware corporation, Battco, Inc. (Battco), intended to carry on the current business of IPS. As its contribution to the transaction, IPS transferred substantially all of its assets to Battco in exchange for five million shares of Battco common stock. The transaction also provides that Millennium and some of the third parties will contribute a combined total of approximately $9 million to a subsequent Battco $25 million preferred stock offering with the remainder coming from outside investors. Millennium committed to fund $3.3 million of the $9 million, of which $1 million has already been funded as a secured convertible loan to be converted to shares of Battco preferred stock at the close of the $25 million financing. MEG is in the process of winding down its activities and does not expect to engage in any new activities after 2005. Millennium is in the process of selling its remaining interest in Nations Energy Corporation (Nations Energy). Millennium's remaining commitments for other Millennium investments are $4 million to Haddington and $3 million to Valley Ventures. In July 2005, Millennium received $4 million as a return of its investment in Carboelectrica Sabinas, S. de R.L. de C.V., (Sabinas) a Mexican limited liability company. As a result of the $4 million payment the book value of the investment in Sabinas was reduced to approximately $14 million. Millennium owns 50% of Sabinas. 57 Also in July 2005, Millennium received a $4 million payment on a note receivable from a subsidiary of Mirant Corporation. We expect to receive the remaining payment of $5 million in July 2006. It is our intention for UniSource Energy to cease making capital contributions to Millennium. We anticipate that the funding required to fund Millennium's remaining commitments will be provided only out of existing Millennium cash or cash returns from Millennium investments. We believe such cash and returns will be adequate to fund Millennium's remaining commitments. CRITICAL ACCOUNTING ESTIMATES - ----------------------------- In preparing financial statements under Generally Accepted Accounting Principles (GAAP), management exercises judgment in the selection and application of accounting principles, including making estimates and assumptions. UniSource Energy and TEP consider Critical Accounting Estimates to be those that could result in materially different financial statement results if our assumptions regarding application of accounting principles were different. UniSource Energy and TEP describe their Critical Accounting Estimates below. Other significant accounting policies and recently issued accounting standards are discussed in the 2004 Annual Report on Form 10-K, Note 1 of Notes to Consolidated Financial Statements - Nature of Operations and Summary of Significant Accounting Estimates. ACCOUNTING FOR RATE REGULATION TEP, UNS Gas and UNS Electric generally use the same accounting policies and practices used by unregulated companies for financial reporting under GAAP. However, sometimes these principles, such as the Financial Accounting Standards Board's (FASB) Statement of Financial Accounting Standards No. 71, Accounting for the Effects of Certain Types of Regulation (FAS 71), require special accounting treatment for regulated companies to show the effect of regulation. For example, in setting TEP, UNS Gas and UNS Electric's retail rates, the ACC may not allow TEP, UNS Gas or UNS Electric to currently charge their customers to recover certain expenses, but instead may require that these expenses be charged to customers in the future. In this situation, FAS 71 requires that TEP, UNS Gas and UNS Electric defer these items and show them as regulatory assets on the balance sheet until TEP, UNS Gas and UNS Electric are allowed to charge their customers. TEP, UNS Gas and UNS Electric then amortize these items as expense to the income statement as these charges are recovered from customers. Similarly, certain revenue items may be deferred as regulatory liabilities, which are also eventually amortized to the income statement as rates to customers are reduced. The conditions a regulated company must satisfy to apply the accounting policies and practices of FAS 71 include: o an independent regulator sets rates; o the regulator sets the rates to recover specific costs of delivering service; and o the service territory lacks competitive pressures to reduce rates below the rates set by the regulator. TEP In November 1999, upon approval by the ACC of the Settlement Agreement relating to recovery of TEP's transition costs and standard retail rates, TEP discontinued application of FAS 71 to its generation operations. TEP's transmission and distribution regulatory assets, net of regulatory liabilities, totaled $201 million at June 30, 2005, $30 million of which is not presently included in the rate base and consequently is not earning a return on investment. These regulatory assets are being recovered through the cost of service or are authorized to be collected in future base rates. TEP's transmission and distribution regulatory assets, net of regulatory liabilities, totaled $225 million at December 31, 2004. TEP continues to apply FAS 71 to its regulated operations, which include the transmission and distribution portions of its business. TEP regularly assesses whether it can continue to apply FAS 71 to these operations. If TEP stopped applying FAS 71 to its remaining regulated operations, it would write off the related balances of its regulatory assets as an expense and its regulatory liabilities as income on its income statement. Based on the regulatory asset balances, net of regulatory liabilities, at June 30, 2005, if TEP had stopped applying FAS 71 to its remaining cost-based regulated operations, it would have recorded an extraordinary after-tax loss of approximately $121 million. While regulatory orders and market conditions may affect cash flows, TEP's cash flows would not be affected if it stopped applying FAS 71 unless a regulatory order limited its ability to recover the cost of its regulatory assets. 58 UNS GAS AND UNS ELECTRIC UNS Gas and UNS Electric's regulatory liabilities, net of regulatory assets, collectively totaled $6 million at June 30, 2005 and $4 million at December 31, 2004. UNS Gas and UNS Electric's regulatory assets and liabilities are included in rate base and consequently are earning a return on investment. If UNS Gas and UNS Electric stopped applying FAS 71 to their regulated operations, they would write off the related balances of regulatory assets as an expense and regulatory liabilities as income on their income statements. Based on the balances of regulatory liabilities and assets at June 30, 2005, if UNS Gas and UNS Electric had stopped applying FAS 71 to their regulated operations, they would have collectively recorded an extraordinary after-tax gain of $3 million. UNS Gas and UNS Electric's cash flows would not be affected if they stopped applying FAS 71 unless a regulatory order limited their ability to recover the cost of their regulatory assets. ACCOUNTING FOR ASSET RETIREMENT OBLIGATIONS FAS 143, issued by the FASB in June 2001, requires entities to record the fair value of a liability for a legal obligation to retire an asset in the period in which the liability is incurred. A legal obligation is a liability that a party is required to settle as a result of an existing or enacted law, statute, ordinance or contract. When the liability is initially recorded, the entity should capitalize a cost by increasing the carrying amount of the related long-lived asset. Over time, the liability is adjusted to its present value by recognizing accretion expense as an operating expense in the income statement each period, and the capitalized cost is depreciated over the useful life of the related asset. Upon settlement of the liability, an entity either settles the obligation for its recorded amount or incurs a gain or loss if the actual costs differ from the recorded amount. TEP Prior to adopting FAS 143, costs for final removal of all owned generation facilities were accrued as an additional component of depreciation expense. Under FAS 143, only the costs to remove an asset with legally binding retirement obligations will be accrued over time through accretion of the asset retirement obligation and depreciation of the capitalized asset retirement cost. TEP has identified legal obligations to retire generation plant assets specified in land leases for its jointly-owned Navajo and Four Corners Generating Stations. The land on which these stations reside is leased from the Navajo Nation. The provisions of the leases require the lessees to remove the facilities upon request of the Navajo Nation at the expiration of the leases. TEP also has certain environmental obligations at the San Juan Generating Station. TEP has estimated that its share of the cost to remove the Navajo and Four Corners facilities and settle the San Juan environmental obligations will be approximately $38 million at the date of retirement. No other legal obligations to retire generation plant assets were identified. On November 12, 2004, TEP, Phelps Dodge Energy Services, LLC and PNM Resources, Inc. each purchased from Duke Energy North America, LLC a one-third interest in a limited liability company which owns the partially constructed natural gas-fired Luna Energy Facility (Luna) in southern New Mexico. Luna is designed as a 570-MW combined cycle plant and is expected to be operational by the summer of 2006. The new owners assumed asset retirement obligations to remove certain piping and evaporation ponds and to restore the ground to its original condition. TEP has estimated its share to settle the obligations will be approximately $2 million at the date of retirement. TEP has various transmission and distribution lines that operate under land leases and rights of way that contain end dates and restorative clauses. TEP operates its transmission and distribution lines as if they will be operated in perpetuity and would continue to be used or sold without land remediation. As a result, TEP is not recognizing the costs of final removal of the transmission and distribution lines in the financial statements. As of June 30, 2005, TEP had accrued $73 million for the net cost of removal for the interim retirements from its transmission, distribution and general plant. As of December 31, 2004, TEP had accrued $67 million for these removal costs. The amount is recorded as a regulatory liability. Amounts recorded under FAS 143 are subject to various assumptions and determinations, such as determining whether a legal obligation exists to remove assets, estimating the fair value of the costs of removal, estimating when final removal will occur, and the credit-adjusted risk-free interest rates to be used to discount future liabilities. Changes that may arise over time with regard to these assumptions and determinations will change amounts recorded in the future as expense for asset retirement obligations. 59 If TEP retires any asset at the end of its useful life, without a legal obligation to do so, it will record retirement costs at that time as incurred or accrued. TEP does not believe that the adoption of FAS 143 will result in any change in retail rates since all matters relating to the rate-making treatment of TEP's generating assets have been determined pursuant to the Settlement Agreement. UES UES has various transmission and distribution lines that operate under land leases and rights of way that contain end dates and restorative clauses. UES operates its transmission and distribution lines as if they will be operated in perpetuity and would continue to be used or sold without land remediation. As a result, UES is not recognizing the cost of final removal of the transmission and distribution lines in the financial statements. UES had accrued $3 million as of June 30, 2005 and $2 million as of December 31, 2004, for the net cost of removal for interim retirements from its transmission, distribution and general plant. The amount is recorded as a regulatory liability. PENSION AND OTHER POST RETIREMENT BENEFIT PLAN ASSUMPTIONS We record plan assets, obligations, and expenses related to pension and other postretirement benefit plans based on actuarial valuations. These valuations include key assumptions on discount rates, expected returns on plan assets, compensation increases and health care cost trend rates. These actuarial assumptions are reviewed annually and modified as appropriate. The effect of modifications is generally recorded or amortized over future periods. We believe that the assumptions used in recording obligations under the plans are reasonable based on prior experience, market conditions and the advice of plan actuaries. TEP TEP discounted its future pension plan obligations at December 31, 2004 using rates of 6.1% for its Salaried and Union Plans and 6.0% for its Excess Benefit Plan. The discount rate used at December 31, 2003 was 6.25% for all plans. TEP discounted its other postretirement plan obligations using a rate of 5.9% at December 31, 2004, compared with 5.5% at December 31, 2003. TEP determines the discount rate annually based on the rates currently available on high-quality, long-term bonds. TEP looks to bonds that receive one of the two highest ratings given by a recognized rating agency whose future cash flows match the timing and amount of expected future benefit payments. The pension liability and future pension expense both increase as the discount rate is reduced. A decrease in the discount rate results in an increase in the Projected Benefit Obligation (PBO) and the service cost component of pension expense. Additionally, the recognized actuarial loss is significantly impacted by a reduction in the discount rate. Since the PBO increases with the decrease in discount rate, the obligation is that much larger than would normally occur due to normal growth of the plan. This leads to an actuarial loss (or a greater actuarial loss than would occur in the absence of the discount rate change), which is amortized over future periods leading to a greater expense. The resulting change in the interest cost component of pension expense is dependent on the effect that the change in the discount rate has on the PBO and will vary based on employee demographics. The effect of the lower rate used to calculate the interest cost is offset to some degree by a larger obligation. The relative magnitude of these two changes determines whether interest cost will increase or decrease. For TEP's pension plans, a 25 basis point decrease in the discount rate would increase the accumulated benefit obligation (ABO) by approximately $5 million and the related plan expense for 2005 by approximately $1 million. A similar increase in the discount rate would decrease the ABO by approximately $5 million and the related plan expense for 2005 by approximately $1 million. For TEP's plan for other postretirement benefits, a 25 basis point change in the discount rate would increase or decrease the accumulated postretirement benefit obligation (APBO) by approximately $2 million. A 25 basis point change in the discount rate would not have a significant impact on the related plan expense for 2005. TEP calculates the market-related value of plan assets using the fair value of plan assets on the measurement date. TEP assumed that its plans' assets would generate a long-term rate of return of 8.5% at December 31, 2004 and 8.75% at December 31, 2003. In establishing its assumption as to the expected return on plan assets, TEP reviews the plans' asset allocation and develops return assumptions for each asset class based on advice from an investment consultant and the plans' actuary that includes both historical performance analysis and forward looking views of the financial markets. Pension expense increases as the expected rate of return on plan assets decreases. A 25 basis point change in the expected return on plan assets would not have a significant impact on pension expense for 2005. 60 TEP used an initial health care cost trend rate of 11.0% in valuing its postretirement benefit obligation at December 31, 2004. This rate reflects both market conditions and the plan's experience. Assumed health care cost trend rates have a significant effect on the amounts reported for health care plans. A 1% increase in assumed health care cost trend rates would increase the postretirement benefit obligation by approximately $5 million and the related plan expense by approximately $1 million. A similar decrease in assumed health care cost trend rates would decrease the postretirement benefit obligation by approximately $4 million and the related plan expense by less than $1 million. TEP recorded a minimum pension liability in Other Comprehensive Income of approximately $20 million at December 31, 2004, compared with $3 million at December 31, 2003. This increase resulted primarily from changes in actuarial assumptions including revised retirements rates, updated mortality rates and a reduction in the assumed discount rate. Based on the above assumptions, TEP will record pension expense of approximately $10 million and other postretirement benefit expense of $7 million ratably throughout 2005. TEP will make required pension plan contributions of $6 million in 2005. TEP's other postretirement benefit plan is not funded. TEP expects to make benefit payments to retirees under the postretirement benefit plan of approximately $3 million in 2005. UNS GAS AND UNS ELECTRIC Concurrent with the acquisition of the Arizona gas and electric system assets from Citizens on August 11, 2003, UES established a pension plan for substantially all employees of UNS Gas and UNS Electric. UES did not assume the pension obligation for employees' years of service with Citizens. UES discounted its future pension plan obligations using a rate of 6.1% at December 31, 2004 and 6.25% at December 31, 2003. For UES' pension plan, a 25 basis point change in the discount rate would have minimal effect on either the ABO or the related pension expense. UES recorded a minimum pension liability and an offsetting Intangible Asset of less than $1 million at December 31, 2004 and approximately $1 million at December 31, 2003. UES will record pension expense of $1 million in 2005. UES will make a pension plan contribution of $1 million in 2005. On the acquisition date, UES assumed the obligation to provide postretirement benefits for a small population of former Citizens employees, both active and retired. The plan is not funded. UES discounted its other postretirement plan obligations using a rate of 5.9% at December 31, 2004, compared with 5.5% at December 31, 2003. Postretirement medical benefit expenses are insignificant to UES' operations. ACCOUNTING FOR DERIVATIVE INSTRUMENTS, TRADING ACTIVITIES AND HEDGING ACTIVITIES A derivative financial instrument or other contract derives its value from another investment or designated benchmark. TEP enters into forward contracts to purchase or sell a specified amount of capacity or energy at a specified price over a given period of time, typically for one month, three months, or one year, within established limits to take advantage of favorable market opportunities. In general, TEP enters into forward purchase contracts when market conditions provide the opportunity to purchase energy for its load at prices that are below the marginal cost of its supply resources or to supplement its own resources (e.g., during plant outages and summer peaking periods). TEP enters into forward sales contracts when it forecasts that it has excess supply and the market price of energy exceeds its marginal cost. The majority of TEP's forward contracts are considered to be normal purchases and sales and, therefore, are not required to be marked to market. However, some of these forward contracts are considered to be derivatives, which TEP marks to market by recording unrealized gains and losses and adjusting the related assets and liabilities on a monthly basis to reflect the market prices at the end of the month. TEP has a natural gas supply agreement under which it purchases all of its gas requirements at spot market prices from Southwest Gas Corporation (SWG). TEP also has agreements to purchase power that are priced using spot market gas prices. These contracts meet the definition of normal purchases and are not required to be marked to market. During 2004 and early 2005, in an effort to minimize price risk on these purchases, TEP entered into commodity price swap agreements under which TEP purchases gas at fixed prices and simultaneously sells gas at spot market prices. The spot market price in the swap agreements is tied to the same index as the purchases under the SWG and purchased power contracts. These swap agreements, which expire during the summer months through 2008, were entered into with the goal of locking in fixed prices on at least 45% and not more than 80% of TEP's expected summer monthly gas risk prior to entering into the month. The swap agreements are marked to market on a monthly basis; however, since the agreements satisfy the requirements for 61 cash flow hedge accounting, the unrealized gains and losses are recorded in Other Comprehensive Income, a component of Common Stock Equity, rather than being reflected in the income statement. As the gains and losses on these cash flow hedges are realized, a reclassification adjustment is recorded in Other Comprehensive Income for realized gains and losses that are included in Net Income. TEP manages the risk of counterparty default by performing financial credit reviews, setting limits, monitoring exposures, requiring collateral when needed, and using a standardized agreement which allows for the netting of current period exposures to and from a single counterparty. UNS Gas and UNS Electric do not currently have any contracts that are required to be marked to market. UNS Gas does have a natural gas supply and management agreement under which it purchases substantially all of its gas requirements at market prices from BP Energy Company (BP). However, the contract terms allow UNS Gas to lock in fixed prices on a portion of its gas purchases by entering into fixed price forward contracts with BP at various times during the year. This enables UNS Gas to provide more stable prices to its customers. These purchases are made up to three years in advance with the goal of locking in fixed prices on at least 45% and not more than 80% of the expected monthly gas consumption prior to entering into the month. These forward contracts, as well as the main gas supply contract, meet the definition of normal purchases and therefore are not required to be marked to market. MEG, a wholly-owned subsidiary of Millennium, enters into swap agreements, options and forward contracts relating to Emissions Allowances and coal. MEG marks its trading contracts to market by recording unrealized gains and losses and adjusting the related assets and liabilities on a monthly basis to reflect the market prices at the end of the month. In accordance with UniSource Energy's intention to cease making capital contributions to Millennium, Millennium has significantly reduced the holdings and activity of MEG. MEG is in the process of winding down its activities and will not engage in any new activities after 2005. The market prices used to determine fair values for TEP and MEG's derivative instruments at June 30, 2005 are estimated based on various factors including broker quotes, exchange prices, over the counter prices and time value. For TEP's forward power contracts, a 10% decrease in market prices would result in a decrease in unrealized losses of less than $1 million, while a 10% increase in market prices would result in an increase in unrealized losses of less than $1 million. For TEP's gas swap agreements, a 10% decrease in market prices would result in a $4 million decrease in unrealized gains reported in Other Comprehensive Income, while a 10% increase in market prices would result in a $4 million increase in unrealized gains reported in Other Comprehensive Income. For MEG's remaining trading contracts, a 10% decrease in market prices or a 10% increase in market prices would be immaterial. Because of the complexity of derivatives, the FASB established a Derivatives Implementation Group (DIG). To date, the DIG has issued more than 100 interpretations to provide guidance in applying Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities (FAS 133). As the DIG or the FASB continues to issue interpretations, TEP, UNS Gas and UNS Electric may change the conclusions they have reached and, as a result, the accounting treatment and financial statement impact could change in the future. See Market Risks - Commodity Price Risk in Item 3. UNBILLED REVENUE - TEP, UNS GAS AND UNS ELECTRIC TEP's, UNS Gas's and UNS Electric's retail revenues include an estimate of MWhs/therms delivered but unbilled at the end of each period. Unbilled revenues are dependent upon a number of factors that require management's judgment including estimates of retail sales and customer usage patterns. The unbilled revenue is estimated by comparing the estimated MWhs/therms delivered to the MWhs/therms billed to TEP, UNS Gas and UNS Electric retail customers. The excess of estimated MWhs/therms delivered over MWhs/therms billed is then allocated to the retail customer classes based on estimated usage by each customer class. TEP, UNS Gas and UNS Electric then record revenue for each customer class based on the various bill rates for each customer class. Due to the seasonal fluctuations of TEP's actual load, the unbilled revenue amount increases during the spring and summer months and decreases during the fall and winter months. The unbilled revenue amount for UNS Gas sales increases during the fall and winter months and decreases during the spring and summer months, whereas, the unbilled revenue amount for UNS Electric sales increases during the spring and summer months and decreases during the fall and winter months. 62 PLANT ASSET DEPRECIABLE LIVES - TEP, UNS GAS AND UNS ELECTRIC We calculate depreciation expense based on our estimate of the useful lives of our plant assets. The estimated useful lives, and resulting depreciation rates used to calculate depreciation expense for the transmission and distribution businesses of TEP, UNS Gas and UNS Electric have been approved by the ACC in prior rate decisions. Depreciation rates for transmission and distribution cannot be changed without ACC approval. The estimated remaining useful lives of TEP's generating facilities are based on management's best estimate of the economic life of the units. These estimates are based on engineering estimates, economic analysis, and statistical analysis of TEP's past experience in maintaining the stations. For 2004, depreciation expense related to generation assets was $35 million, and our generation assets are currently depreciated over periods ranging from 23 to 70 years from the original in-service dates. During the first quarter of 2004, TEP engaged an independent third party to review the economic estimated useful lives of its owned generating assets in Springerville, Arizona. TEP then hired a different independent third party to perform a depreciation study for its generation assets, taking into consideration the newly determined economic useful life for the Springerville assets, and changes in generation plant life information used by the operators and other participants of the joint power plants in which TEP participates. As a result of these analyses, TEP lengthened the useful lives of various generation assets for periods ranging from 11 to 22 years in July 2004. Consequently, depreciation rates and the corresponding depreciation expense have been revised prospectively to reflect the life extensions. The annual impact of these changes in depreciation rates is a reduction in depreciation expense of $9 million. During the second quarter of 2005, a study requested by the participants in the San Juan Generating Station was completed which indicated San Juan's economic useful life had changed from previous estimates. As a result of the study and other analysis performed, TEP lengthened the estimated useful life of San Juan from 40 to 60 years beginning April 1, 2005. TEP's depreciation expense for the three months ended June 30, 2005, decreased $2 million. Annual depreciation expense is expected to decrease by $6 million or $3 million for the remainder of 2005. DEFERRED TAX VALUATION - TEP AND MILLENNIUM We record deferred tax liabilities for amounts that will increase income taxes on future tax returns. We record deferred tax assets for amounts that could be used to reduce income taxes on future tax returns. We record a valuation allowance, or reserve, for the deferred tax asset amount that we may not be able to use on future tax returns. We estimate the valuation allowance based on our interpretation of the tax rules, prior tax audits, tax planning strategies, scheduled reversal of deferred tax liabilities, and projected future taxable income. At June 30, 2005 and December 31, 2004, UniSource Energy and TEP had a valuation allowance of $8 million relating to net operating loss (NOL) and investment tax credit (ITC) carryforward amounts. Of the $8 million valuation allowance balance at June 30, 2005 and December 31, 2004, $7 million relates to losses generated by the Millennium entities. In the future, if UniSource Energy and the Millennium entities determine that all or a portion of the losses may be used on tax returns, then UniSource Energy and the Millennium entities would reduce the valuation allowance and recognize a tax benefit of up to $7 million. The primary factor that could cause the Millennium entities to recognize a tax benefit would be a change in expected future taxable income. The remaining $1 million of valuation allowance balance at June 30, 2005 and December 31, 2004, relates to ITC carryforwards at TEP which may not be utilized on tax returns prior to their expiration. If in the future UniSource Energy and TEP determine that it is probable that TEP will not use all or a portion of additional ITC carryforward amounts, then UniSource Energy and TEP would record additional valuation allowance and recognize tax expense. The primary factor that could cause TEP to record additional valuation allowance would be a change in expected future taxable income. As of June 30, 2005 and December 31, 2004, UniSource Energy's deferred income tax assets include $15 million and $14 million, respectively, related to unregulated investment losses of Millennium. As of June 30, 2005 and December 31, 2004, TEP's deferred income tax assets include $1 million related to TEP's unregulated investment losses. These losses have not been reflected on UniSource Energy's consolidated income tax returns. If UniSource Energy is unable to recognize such losses through its consolidated income tax return in the foreseeable future, UniSource Energy and TEP would be required to write off these deferred tax assets. Millennium intends to restructure its ownership in two of these investments, Infinite Power Solutions (IPS) and 63 Corporacion Panama de Energia S.A. (Copesa), in 2005. As a result of these actions, UniSource Energy expects to liquidate IPS for tax purposes and dispose of its stock interest in Copesa, both resulting in taxable losses that will be reflected on UniSource Energy's consolidated income tax return. If these actions, or other actions resulting in the recognition of the losses for tax purposes, do not occur, UniSource Energy would be required to eliminate the deferred tax assets and recognize additional tax expense of $9 million. NEW ACCOUNTING PRONOUNCEMENTS - ----------------------------- The FASB recently issued the following Statements of Financial Accounting Standards (FAS), FASB Interpretations (FIN), and FASB Staff Positions (FSP): o FIN 47, Accounting for Conditional Asset Retirement Obligations, issued March 2005, provides guidance for a legal obligation to perform an asset retirement activity in which the timing and (or) method of settlement are conditional on a future event that may or may not be within the control of the entity. The obligation to perform the asset retirement activity is unconditional even though uncertainty exists about the timing and (or) method of settlement. FIN 47 requires a liability be recognized for the fair value of a conditional asset retirement obligation if the fair value can be reasonably estimated. FIN 47 is required to be applied by December 31, 2005. We are evaluating the impact on our financial position and results of operations of the adoption of FIN 47. o FSP FIN 46(R)-5, Implicit Variable Interests under FASB Interpretation No. 46 (revised December 2003), Consolidation of Variable Interest Entities, issued March 2005, addresses whether a reporting enterprise should consider whether it holds an implicit variable interest in a variable interest entity (VIE) or potential VIE when specific conditions exist. The guidance in FSP FIN 46(R)-5 was effective April 1, 2005, and did not have a significant impact on our financial statements. o FAS 151, Inventory Costs, issued November 2004, is an amendment of Accounting Research Bulletin (ARB) No. 43, Chapter 4, Inventory Pricing. FAS 151 clarifies that abnormal amounts of idle facility expense, freight, handling costs, and wasted materials (spoilage) should be recognized as current-period charges. FAS 151 also requires the allocation of fixed production overheads to inventory based on the normal capacity of the production facilities. FAS 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The adoption of FAS 151 is not expected to have a significant impact on our financial statements. o FAS 153, Exchanges of Nonmonetary Assets, issued December 2004, requires nonmonetary exchanges be accounted for at fair value, recognizing any gains or losses, if their fair value is determinable within reasonable limits and the transaction has commercial substance. A nonmonetary exchange has commercial substance if future cash flows of the entity are expected to change significantly as a result of the exchange. FAS 153 is effective for nonmonetary asset exchange transactions occurring in fiscal periods beginning after June 15, 2005. The adoption of FAS 153 is not expected to have a significant impact on our financial statements. o FAS 154, Accounting Changes and Error Corrections, issued May 2005, provides guidance on the accounting for and reporting of accounting changes and error corrections. FAS 154 requires retrospective application to prior periods' for a voluntary change in accounting principle, unless it is impracticable to do so. FAS 154 also provides guidance related to the reporting of a change in accounting estimate, a change in reporting entity and the correction of an error. FAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The adoption of FAS 154 is not expected to have a significant impact on our financial statements. o FSP FAS 109-1, Application of FASB Statement No. 109, Accounting for Income Taxes, to the Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of 2004, issued in December 2004, provides guidance on the application of FAS 109 to the provision within the American Jobs Creation Act of 2004 that provides a tax deduction, beginning in 2005, on qualified production activities, including a company's electric generation activities. Under FSP FAS 109-1, recognition of the tax deduction on qualified production activities is ordinarily reported in the year it is earned. FSP FAS 109-1 did not have a significant impact on our financial statements in the first six months of 2005. We are evaluating the impact of FSP FAS 109-1 on our financial position and results of operations for the remainder of the year. In June 2004, the EITF published Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments (EITF 03-1). EITF 03-1 provides application guidance on impairment of securities accounted for under FAS 115, Accounting for Certain Investments in Debt and Equity Securities, and cost method investments and requires certain quantitative and qualitative disclosures for securities that are impaired at the balance sheet date but for which an other-than-temporary impairment has not been recognized. The disclosure requirements are effective for reporting periods ending after December 31, 2003. The FASB 64 issued FSP EITF Issue 03-1-1, Effective Date of Paragraphs 10-20 of EITF Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments in September 2004 delaying the effective date of the application guidance on impairment of securities until the final issuance of FSP EITF Issue 03-1-a. As of August 4, 2005, a final FSP EITF Issue 03-1-a has not been issued. The adoption of EITF 03-1 is not expected to have a significant impact on our financial statements. SAFE HARBOR FOR FORWARD-LOOKING STATEMENTS - ------------------------------------------ This Quarterly Report on Form 10-Q contains forward-looking statements as defined by the Private Securities Litigation Reform Act of 1995. UniSource Energy and TEP are including the following cautionary statements to make applicable and take advantage of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 for any forward-looking statements made by or for UniSource Energy or TEP in this Quarterly Report on Form 10-Q. Forward-looking statements include statements concerning plans, objectives, goals, strategies, future events or performance and underlying assumptions and other statements that are not statements of historical facts. Forward-looking statements may be identified by the use of words such as "anticipates", "estimates", "expects", "intends", "plans", "predicts", "projects", and similar expressions. From time to time, we may publish or otherwise make available forward-looking statements of this nature. All such forward-looking statements, whether written or oral, and whether made by or on behalf of UniSource Energy or TEP, are expressly qualified by these cautionary statements and any other cautionary statements which may accompany the forward-looking statements. In addition, UniSource Energy and TEP disclaim any obligation to update any forward-looking statements to reflect events or circumstances after the date of this report. Forward-looking statements involve risks and uncertainties, which could cause actual results or outcomes to differ materially from those expressed in the forward-looking statements. We express our expectations, beliefs and projections in good faith and believe them to have a reasonable basis. However, we make no assurances that management's expectations, beliefs or projections will be achieved or accomplished. We have identified the following important factors that could cause actual results to differ materially from those discussed in our forward-looking statements. These may be in addition to other factors and matters discussed in other parts of this report: 1. Effects of restructuring initiatives in the electric industry and other energy-related industries. 2. Effects of competition in retail and wholesale energy markets. 3. Changes in economic conditions, demographic patterns and weather conditions in our retail service areas. 4. Supply and demand conditions in wholesale energy markets, including volatility in market prices and illiquidity in markets, which are affected by a variety of factors. These factors include the availability of generating capacity in the western U.S., including hydroelectric resources, weather, natural gas prices, the extent of utility restructuring in various states, transmission constraints, environmental regulations and cost of compliance, FERC regulation of wholesale energy markets, and economic conditions in the western U.S. 5. The creditworthiness of the entities with which we transact business or have transacted business. 6. Changes affecting our cost of providing electrical service including changes in fuel costs, generating unit operating performance, scheduled and unscheduled plant outages, interest rates, tax laws, environmental laws, and the general rate of inflation. 7. Changes in governmental policies and regulatory actions with respect to financing and rate structures. 8. Changes affecting the cost of competing energy alternatives, including changes in available generating technologies and changes in the cost of natural gas. 9. Changes in accounting principles or the application of such principles to our businesses. 10. Changes in the depreciable lives of our assets. 11. Market conditions and technological changes affecting our unregulated businesses. 65 12. Unanticipated changes in future liabilities relating to employee benefit plans due to changes in market values of retirement plan assets and health care costs. 13. The outcome of any ongoing or future litigation. 14. Ability to obtain financing through debt and/or equity issuance, which can be affected by various factors, including interest rate fluctuations and capital market conditions. ITEM 3. - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK - -------------------------------------------------------------------- The information contained in this Item updates, and should be read in conjunction with, information included in Part II, Item 7A in UniSource Energy and TEP's Annual Report on Form 10-K for the year ended December 31, 2004, in addition to the interim condensed consolidated financial statements and accompanying notes presented in Items 1 and 2 of this Form 10-Q. We are exposed to various forms of market risk. Changes in interest rates, returns on marketable securities, and changes in commodity prices may affect our future financial results. The market risks resulting from changes in interest rates and returns on marketable securities have not changed materially from the market risks reported in the 2004 Annual Report on Form 10-K. For additional information concerning risk factors, including market risks, see Safe Harbor for Forward-Looking Statements, above. RISK MANAGEMENT COMMITTEE We have a Risk Management Committee responsible for the oversight of commodity price risk and credit risk related to the wholesale energy marketing activities of TEP, the emissions and coal trading activities of MEG, and the fuel and power procurement activities at TEP and UES. Our Risk Management Committee, which meets on a quarterly basis and as needed, consists of officers from the finance, accounting, legal, wholesale marketing, transmission and distribution operations, and the generation operations departments of UniSource Energy. To limit TEP's, UES' and MEG's exposure to commodity price risk, the Risk Management Committee sets trading and hedging policies and limits, which are reviewed frequently to respond to constantly changing market conditions. To limit TEP's, UES' and MEG's exposure to credit risk, the Risk Management Committee reviews counterparty credit exposure, as well as credit policies and limits. COMMODITY PRICE RISK We are exposed to commodity price risk primarily relating to changes in the market price of electricity, natural gas, coal and Emissions Allowances. TEP To manage its exposure to energy price risk, TEP enters into forward contracts to buy or sell energy at a specified price and future delivery period. Generally, TEP commits to future sales based on expected excess generating capability, forward prices and generation costs, using a diversified market approach to provide a balance between long-term, mid-term and spot energy sales. TEP generally enters into forward purchases during its summer peaking period to ensure it can meet its load and reserve requirements and account for other contracts and resource contingencies. TEP also enters into limited forward purchases and sales to optimize its resource portfolio and take advantage of locational differences in price. These positions are managed on both a volumetric and dollar basis and are closely monitored using risk management policies and procedures overseen by the Risk Management Committee. For example, the risk management policies provide that TEP should not take a short position in the third quarter and must have owned generation backing up all forward sales positions at the time the sale is made. TEP's risk management policies also restrict entering into forward positions with maturities extending beyond the end of the next calendar year except for approved hedging purposes. The majority of TEP's forward contracts are considered to be "normal purchases and sales" of electric energy and are not considered to be derivatives under FAS 133. TEP records revenues on its "normal sales" and expenses on its "normal purchases" in the period in which the energy is delivered. From time to time, however, TEP enters into forward contracts that meet the definition of a derivative under FAS 133. When TEP has derivative forward contracts, it marks them to market on a daily basis using actively quoted prices obtained from brokers for power traded over-the-counter at Palo Verde and at other southwestern U.S. trading hubs. TEP believes that these broker quotations used to calculate the mark-to-market values represent accurate measures of 66 the fair values of TEP's positions, because of the short-term nature of TEP's positions, as limited by risk management policies, and the liquidity in the short-term market. As of June 30, 2005, all of TEP's derivative forward contracts were for settlement within 6 months. To adjust the value of its derivative forward contracts to fair value on its income statement, TEP recorded net unrealized gains of less than $1 million on its income statements for the three month periods ended June 30, 2005 and 2004, respectively. TEP is also subject to commodity price risk from changes in the price of natural gas. In addition to energy from its coal-fired facilities, TEP typically uses purchased power, supplemented by generation from its gas-fired units, to meet the summer peak demands of its retail customers and to meet local reliability needs. Some of these purchased power contracts are price indexed to natural gas prices. Short-term and spot power purchase prices are also closely correlated to natural gas prices. Due to its increasing seasonal gas and purchased power usage, TEP hedges a portion of its total natural gas exposure from plant fuel, gas-indexed purchase power and spot market purchases with fixed price contracts for a maximum of three years. TEP purchases its remaining gas fuel needs and purchased power in the spot and short-term markets. In the first six months of 2005, the average price of natural gas was $5.83 per MMBtu, or 12% higher than the same period in 2004. TEP's generation output fueled by natural gas was approximately 145,000 MWh, or 2% of total generation and purchased power in the first six months of 2005. During the first six months of 2005, TEP purchased a total of 681,000 MWh of energy, or 11% of total generation and purchased power. In January 2005, TEP entered into a purchased power agreement with Panda Gila River. TEP will purchase 50 MW of firm on-peak energy during June through September 2005. TEP entered into two purchased power agreements in 2003 for the period 2003 through 2006. During 2004, and through the first six months of 2005, TEP purchased approximately 175,000 and 75,000 MWh, respectively under these contracts. Energy prices under these agreements are adjusted for changes in the price of natural gas. UES UES is also subject to commodity price risk, primarily from the changes in the price of natural gas purchased for its UNS Gas customers. This risk is mitigated through the PGA mechanism in UNS Gas' retail rates which provides an adjustment to recover the actual costs of gas and transportation. UNS Gas further reduces this risk by purchasing forward fixed price contracts for a portion of its projected gas needs under its Price Stabilization Plan. UNS Gas purchases between 45% and 80% of its estimated gas needs in this manner. UNS Electric is not exposed to commodity price risk for its purchase of electricity as it has a fixed price full-requirements supply agreement with PWCC through May 2008. MEG During the fourth quarter of 2001, MEG began managing and trading Emissions Allowances, coal and related instruments. We manage the market risk of this line of business by setting notional limits by product, as well as limits to the potential change in fair market value under a 33% change in price or volatility. We closely monitor MEG's trading activities, which include swap agreements, options and forward contracts, using risk management policies and procedures overseen by the Risk Management Committee. MEG marks its trading positions to market on a daily basis using actively quoted prices obtained from brokers and options pricing models for positions that extend through 2007. As of June 30, 2005 and December 31, 2004, the fair value of MEG's trading assets combined with Emissions Allowances it holds in escrow was $18 million and $77 million, respectively. The fair value of MEG's trading liabilities was $14 million at June 30, 2005 and $65 million at December 31, 2004. For the six months ended June 30, 2005, MEG reflected a $7 million unrealized gain and $7 million realized loss on its income statement, compared with an unrealized gain of $2 million and a realized loss of $2 million for the six months ended June 30, 2004. 67 MEG is in the process of winding down its activities and does not expect to engage in any new activities after 2005.
Unrealized Gain (Loss) of MEG's Trading Activities - Millions of Dollars - Maturity 0 - 6 Maturity 6 - 12 Maturity over Total Source of Fair Value At June 30, 2005 months months 1 yr. Unrealized Gain (Loss) - ---------------------------------------------------- ----------------- ------------------ --------------- ----------------- Prices actively quoted $ 4 $ - $ - $ 4 Prices based on models and other valuation methods - - 6 6 - ---------------------------------------------------- ----------------- ------------------ --------------- ----------------- Total $ 4 $ - $ 6 $ 10 ==================================================== ================= ================== =============== =================
CREDIT RISK UniSource Energy is exposed to credit risk in its energy-related marketing and trading activities related to potential nonperformance by counterparties. We manage the risk of counterparty default by performing financial credit reviews, setting limits monitoring exposures, requiring collateral when needed, and using a standard agreement which allows for the netting of current period exposures to and from a single counterparty. We calculate counterparty credit exposure by adding any outstanding receivable (net of amounts payable if a netting agreement exists) to the mark-to-market value of any forward contracts. As of June 30, 2005, TEP's total credit exposure related to its wholesale marketing activities was approximately $14 million and MEG's total credit exposure related to its trading activities was $6 million. TEP and MEG's credit exposure is diversified across approximately 23 counterparties. Approximately $1 million of exposure is to non-investment grade companies. UniSource Energy is also exposed to credit risk related to the sale of assets owned by Nations Energy Corporation (Nations Energy). In September 2001, Nations Energy sold its equity interest in a power project to a subsidiary of Mirant Corporation (Mirant). Nations Energy received $5 million in cash and an $11 million note receivable from Mirant. The note was recorded at its net present value of $8 million. As of June 30, 2005, Nations Energy's receivable from Mirant is approximately $9 million. The first payment of $2 million on the receivable was received in June 2004 and the second payment of $4 million was received in July 2005. The remaining payment of $5 million is expected to be received in July 2006. Nations Energy expects to collect the note in its entirety. ITEM 4. - CONTROLS AND PROCEDURES - -------------------------------------------------------------------------------- UniSource Energy and TEP have disclosure controls and procedures to ensure that material information recorded, processed, summarized and reported in their filings with the SEC is accurate and reported on a timely basis. Management of UniSource Energy and TEP, with the participation of the principal executive officer and principal financial officer of UniSource Energy and TEP, have evaluated these disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended) as of June 30, 2005. Based on such evaluation, the principal executive officer and principal financial officer of UniSource Energy and TEP have concluded that such disclosure controls and procedures were, as of such date, effective at ensuring that material information is recorded, processed, summarized and reported accurately and within the time periods specified by the SEC's rules and forms. During the fiscal quarter ended June 30, 2005, there have not been any changes in UniSource Energy or TEP's internal controls over financial reporting that have materially affected, or are reasonably likely to materially affect, these controls. 68 PART II - OTHER INFORMATION ITEM 1. - LEGAL PROCEEDINGS - -------------------------------------------------------------------------------- See Item 7. - Management's Discussion and Analysis of Financial Condition and Results of Operations, Tucson Electric Power Company, Factors Affecting Operations, for litigation related to ACC orders and retail competition. We discuss other legal proceedings in Note 6 of Notes to Condensed Consolidated Financial Statements. CROSS-COMPLAINTS IN WHOLESALE ELECTRICITY ANTITRUST CASES I AND II In late 2000, various California municipalities and citizens filed suits against Duke Energy Trading and Marketing, L.L.C., Reliant Energy Services, Inc. and other large suppliers of wholesale electricity alleging that Duke, Reliant, and the other large suppliers violated antitrust laws by colluding to effect the price of electricity in the California wholesale electricity market. These actions were subsequently consolidated in San Diego Superior Court in March 2002 as Wholesale Electricity Antitrust Cases I and II. Duke and Reliant responded by filing cross-complaints against TEP and numerous other wholesale electricity market participants in April 2002. The cross complaints allege that cross-defendants sold power in significant amounts at prices the antitrust plaintiffs allege were excessive, and as participants in power sales, cross-defendants are equally liable for plaintiffs alleged damages. The entire action was removed to the United States District Court for the Southern District of California in May 2002. The antitrust plaintiffs responded to the removal by filing a motion for remand, and on December 13, 2002, the District Court remanded the case back to state court. Duke and Reliant appealed the District Court's remand order and requested that the order be stayed pending resolution of their appeal. On December 8, 2004, the Ninth Circuit affirmed the District Court's remand and similarly denied a subsequent petition for rehearing and motion to recall the mandate. The case has now been remanded to the state court and TEP filed a demurrer to the cross-complaints. TEP believes these claims are without merit and intends to vigorously contest them. CITY OF TACOMA On June 7, 2004, the City of Tacoma, Washington filed a lawsuit (City of Tacoma v. American Electric Power Services Corporation, et al. (U.S. District Ct. W. D. Wash.)) against TEP and various other electricity generators and marketers alleging that the defendants violated antitrust laws by colluding to effect the price of electricity in the Pacific Northwest from May 2000 through 2001. These claims are similar to those alleged in the antitrust cases against TEP and other wholesale electricity market participants described above in Cross-Complaints in Wholesale Electricity Antitrust Cases I and II. On September 14, 2004, the case was transferred to the United States District Court for the Southern District of California. TEP along with other defendants filed a joint motion to dismiss and the motion was granted on February 11, 2005. The City of Tacoma appealed the dismissal to the Ninth Circuit and the appeal is now pending. TEP believes these claims are without merit and intends to vigorously contest them. 69 ITEM 4. - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - -------------------------------------------------------------------------------- UniSource Energy conducted its annual meeting of shareholders on May 6, 2005. At that meeting, the shareholders of UniSource Energy elected members of the Board of Directors. The total votes were as follows:
NOMINEE VOTES FOR WITHHELD ------------------------------ ------------------------------- ----------------------------------- Lawrence J. Aldrich 29,967,903 2,919,085 Larry W. Bickle 29,963,818 2,923,170 Elizabeth T. Bilby 32,553,164 333,824 Harold W. Burlingame 32,634,297 252,691 John L. Carter 32,629,874 257,114 Robert A. Elliott 32,630,222 256,766 Kenneth Handy 32,637,771 249,217 Warren Y. Jobe 32,474,261 412,727 James S. Pignatelli 32,653,098 233,890 ----------------------------- ------------------------------- -----------------------------------
ITEM 5. - OTHER INFORMATION - -------------------------------------------------------------------------------- NON-GAAP MEASURES ADJUSTED EBITDA --------------- Adjusted EBITDA represents EBITDA excluding the cumulative effect of accounting change which is a non-cash item. EBITDA is earnings before interest, taxes, depreciation and amortization. Adjusted EBITDA is presented here as a measure of liquidity because it can be used as an indication of a company's ability to incur and service debt and is commonly used as an analytical indicator in our industry. Adjusted EBITDA measures presented may not be comparable to similarly titled measures used by other companies. Adjusted EBITDA is not a measurement presented in accordance with United States generally accepted accounting principles (GAAP), and we do not intend Adjusted EBITDA to represent cash flows from operations as defined by GAAP. Adjusted EBITDA should not be considered to be an alternative to cash flows from operations or any other items calculated in accordance with GAAP or an indicator of our operating performance. UniSource Energy and TEP view Adjusted EBITDA, a non-GAAP financial measure, as a liquidity measure. The most directly comparable GAAP measure to Adjusted EBITDA is Net Cash Flows from Operating Activities. ADJUSTED EBITDA AND NET CASH FLOWS FROM OPERATING ACTIVITIES
UNISOURCE ENERGY ------------------------------------------------------------- THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, JUNE 30, - ----------------------------------------------------------------- ------------------------------ ------------------------------ UNISOURCE ENERGY 2005 2004 2005 2004 - Millions of Dollars - Adjusted EBITDA $ 108 $ 115 $ 191 $ 216 Net Cash Flows from Operating Activities $ 51 $ 97 $ 91 $ 141
70
TEP ------------------------------------------------------------- THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, JUNE 30, - ----------------------------------------------------------------- ------------------------------ ------------------------------ TEP 2005 2004 2005 2004 - Millions of Dollars - Adjusted EBITDA $ 102 $ 115 $ 174 $ 199 Net Cash Flows from Operating Activities $ 37 $ 83 $ 74 $ 119 RECONCILIATION OF ADJUSTED EBITDA TO CASH FLOWS FROM OPERATIONS UNISOURCE ENERGY ------------------------------------------------------------- THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, JUNE 30, - ----------------------------------------------------------------- ------------------------------ ------------------------------ 2005 2004 2005 2004 - Millions of Dollars - ADJUSTED EBITDA (1) $ 108 $ 115 $ 191 $ 216 Amounts from the Income Statements: Less: Income Taxes 7 12 6 18 Less: Total Interest Expense 44 40 84 83 Changes in Assets and Liabilities and Other Non-Cash Items (6) 34 (10) 26 - ----------------------------------------------------------------- --------------- -------------- -------------- --------------- NET CASH FLOWS FROM OPERATING ACTIVITIES $ 51 $ 97 $ 91 $ 141 ================================================================= =============== ============== ============== =============== TEP ------------------------------------------------------------- THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, JUNE 30, - ----------------------------------------------------------------- ------------------------------ ------------------------------ 2005 2004 2005 2004 - Millions of Dollars - ADJUSTED EBITDA (1) $ 102 $ 115 $ 174 $ 199 Amounts from the Income Statements: Less: Income Taxes 9 15 7 17 Less: Total Interest Expense 38 37 75 77 Changes in Assets and Liabilities and Other Non-Cash Items (18) 20 (18) 14 - ----------------------------------------------------------------- --------------- -------------- -------------- --------------- NET CASH FLOWS FROM OPERATING ACTIVITIES $ 37 $ 83 $ 74 $ 119 ================================================================= =============== ============== ============== ===============
71 (1) ADJUSTED EBITDA WAS CALCULATED AS FOLLOWS:
UNISOURCE ENERGY ------------------------------------------------------------- THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, JUNE 30, ------------------------------ ------------------------------ 2005 2004 2005 2004 - Millions of Dollars - NET INCOME $ 9 $ 13 $ 6 $ 19 Amounts from the Income Statements: Plus: Income Taxes 7 12 6 18 Plus: Total Interest Expense 44 40 84 83 Plus: Depreciation and Amortization 33 37 68 72 Plus: Amortization of Transition Recovery Asset 14 12 24 21 Plus: Depreciation included in Fuel and Other O&M Expense (see Note 13 of Notes to Consolidated Financial Statements) 1 1 3 3 - ----------------------------------------------------------------- --------------- -------------- -------------- --------------- ADJUSTED EBITDA $ 108 $ 115 $ 191 $ 216 ================================================================= =============== ============== ============== =============== TEP ------------------------------------------------------------- THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, JUNE 30, ------------------------------ ------------------------------ 2005 2004 2005 2004 - Millions of Dollars - NET INCOME $ 12 $ 18 $ 7 $ 19 Amounts from the Income Statements: Plus: Income Taxes 9 15 7 17 Plus: Total Interest Expense 38 37 75 77 Plus: Depreciation and Amortization 28 32 58 62 Plus: Amortization of Transition Recovery Asset 14 12 24 21 Plus: Depreciation included in Fuel and Other O&M Expense (see Note 13 of Notes to Consolidated Financial Statements) 1 1 3 3 - ----------------------------------------------------------------- --------------- -------------- -------------- --------------- ADJUSTED EBITDA $ 102 $ 115 $ 174 $ 199 ================================================================= =============== ============== ============== ===============
NET DEBT AND TOTAL DEBT AND CAPITAL LEASE OBLIGATIONS - TEP - ----------------------------------------------------------- Net Debt represents the current and non-current portions of TEP's long-term debt and capital lease obligations less investment in lease debt. We have subtracted investment in lease debt because it represents TEP's ownership of the debt component of its own capital lease obligations. Net Debt measures presented may not be comparable to similarly titled measures used by other companies. Net Debt is not a measurement presented in accordance with GAAP and we do not intend Net Debt to represent debt as defined by GAAP. You should not consider Net Debt to be an alternative to debt or any other items calculated in accordance with GAAP.
AS OF AS OF JUNE 30, 2005 DECEMBER 31, 2004 - -------------------------------------------------- -------------- ------------------- - Millions of Dollars - Net Debt $ 1,375 $ 1,684 Total Debt and Capital Lease Obligations $ 1,537 $ 1,855 - -------------------------------------------------- -------------- -------------------
72 RECONCILIATION OF TOTAL DEBT AND CAPITAL LEASE OBLIGATIONS TO NET DEBT
AS OF AS OF JUNE 30, 2005 DECEMBER 31, 2004 - ---------------------------------------------------------- -------------- ------------------- - Millions of Dollars - Long-Term Debt $ 821 $ 1,098 Current Portion - Long-Term Debt - 2 - ---------------------------------------------------------- -------------- ------------------- TOTAL DEBT 821 1,100 - ---------------------------------------------------------- -------------- ------------------- Capital Lease Obligations 660 701 Current Portion - Capital Lease Obligations 56 54 - ---------------------------------------------------------- -------------- ------------------- TOTAL DEBT AND CAPITAL LEASE OBLIGATIONS 1,537 1,855 - ---------------------------------------------------------- -------------- ------------------- Investment in Lease Debt (162) (171) - ---------------------------------------------------------- -------------- ------------------- NET DEBT $ 1,375 $ 1,684 ========================================================== ============== ===================
RATIO OF EARNINGS TO FIXED CHARGES - ---------------------------------- The following table reflects the ratio of earnings to fixed charges for UniSource Energy and TEP:
6 Months Ended 12 Months Ended June 30, 2005 June 30, 2005 - ----------------------------------------- ---------------------- ------------------------- UniSource Energy 1.15 1.32 TEP 1.20 1.39
SEC REPORTS AVAILABLE ON UNISOURCE ENERGY'S WEBSITE - --------------------------------------------------- UniSource Energy and TEP make available their annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports as soon as reasonably practicable after they electronically file them with, or furnish them to, the SEC. These reports are available free of charge through UniSource Energy's website address: http://www.unisourceenergy.com. A link from UniSource Energy's website to these SEC reports is accessible as follows: At the UniSource Energy main page, select Investor Relations from the menu shown at the top of the page; next select SEC filings from the menu shown on the Investor Relations page. Information contained at UniSource Energy's website is not part of any report filed with the SEC by UniSource Energy or TEP. The SEC also maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC. The SEC website address is http://www.sec.gov. Interested parties may also read and copy any materials UniSource Energy or TEP file with the SEC at the SEC's Public Reference Room at 450 Fifth Street, NW, Washington, DC 20549. Information on the operation of the Public Reference Room is available by calling the SEC at 1-800-SEC-0030. ITEM 6. - EXHIBITS - -------------------------------------------------------------------------------- See Exhibit Index. 73 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, each registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. The signature for each undersigned company shall be deemed to relate only to matters having reference to such company or its subsidiaries. UNISOURCE ENERGY CORPORATION ---------------------------- (Registrant) Date: August 9, 2005 /s/ Kevin P. Larson ----------------------------------- Kevin P. Larson Vice President and Principal Financial Officer TUCSON ELECTRIC POWER COMPANY ----------------------------- (Registrant) Date: August 9, 2005 /s/ Kevin P. Larson ----------------------------------- Kevin P. Larson Vice President and Principal Financial Officer 74 EXHIBIT INDEX ------------- 12(a) -- Computation of Ratio of Earnings to Fixed Charges - UniSource Energy. 12(b) -- Computation of Ratio of Earnings to Fixed Charges - TEP. 15 -- Letter regarding unaudited interim financial information. 31(a) -- Certification Pursuant to Section 302 of the Sarbanes-Oxley Act - UniSource Energy, by James S. Pignatelli. 31(b) -- Certification Pursuant to Section 302 of the Sarbanes-Oxley Act - UniSource Energy, by Kevin P. Larson. 31(c) -- Certification Pursuant to Section 302 of the Sarbanes-Oxley Act - TEP, by James S. Pignatelli. 31(d) -- Certification Pursuant to Section 302 of the Sarbanes-Oxley Act - TEP, by Kevin P. Larson. *32 -- Statements of Corporate Officers (pursuant to Section 906 of the Sarbanes-Oxley Act of 2002). *Pursuant to Item 601(b)(32)(ii) of Regulation S-K, this certificate is not being filed for purposes of Section 18 of the Securities Exchange Act of 1934. 75 EX-12 2 exhibit12a.txt EXHIBIT 12(A) - RATIO OF EARNINGS (UNISOURCE) Exhibit 12(a) UNISOURE ENERGY CORPORATION Computation of Ratio of Earnings to Fixed Charges
6 Months 12 Months | 12 Months Ended Ended Ended | --------------------------------------------------------------------------- Jun. 30 Jun. 30 | Dec. 31, Dec. 31, Dec. 31, Dec. 31, Dec. 31, 2005 2005 | 2004 2003 2002 2001 2000 - ------------------------------------------------------------------------------------------------------------------ | - Thousands of Dollars - FIXED CHARGES: | Interest on Long-Term Debt $ 40,096 $ 79,753 | $ 82,807 $ 80,844 $ 65,620 $ 68,678 $ 75,076 Other Interest (1) 1,503 2,852 | 2,098 3,709 2,123 1,287 219 Interest on Capital Lease Obligations 39,147 84,949 | 85,912 84,080 87,801 90,559 92,869 - ------------------------------------------------------------------------------------------------------------------ TOTAL FIXED CHARGES 80,746 167,554 | 170,817 168,633 155,544 160,524 168,164 | NET INCOME 5,685 32,382 | 45,919 113,941 34,928 63,839 43,484 | LESS: | Extraordinary Income & Accounting Change - | Net of Tax - - | - 67,471 - 470 - - ------------------------------------------------------------------------------------------------------------------ NET INCOME FROM CONTINUING OPERATIONS 5,685 32,382 | 45,919 46,470 34,928 63,369 43,484 | ADD (DEDUCT): | (Income) Losses from Equity Investees 730 (172)| (7,121) 3,051 3,047 10,748 3,335 Income Taxes 5,652 22,037 | 33,946 12,082 17,962 49,109 16,199 Total Fixed Charges 80,746 167,554 | 170,817 168,633 155,544 160,524 168,164 - ------------------------------------------------------------------------------------------------------------------ | TOTAL EARNINGS BEFORE TAXES | AND FIXED CHARGES $ 92,813 $ 221,801 | $243,561 $230,236 $211,481 $283,750 $ 231,182 ================================================================================================================== | | RATIO OF EARNINGS TO FIXED CHARGES 1.149 1.324 | 1.426 1.365 1.360 1.768 1.375 (1) Excludes recognition of Allowance for Borrowed Funds Used During Construction.
EX-12 3 exhibit12b.txt EXHIBIT 12(B) - RATIO OF EARNINGS (TUSCON) Exhibit 12(b) TUCSON ELECTRIC POWER COMPANY Computation of Ratio of Earnings to Fixed Charges
3 Months 12 Months | 12 Months Ended Ended Ended | --------------------------------------------------------------------------- Jun. 30 Jun. 30 | Dec. 31, Dec. 31, Dec. 31, Dec. 31, Dec. 31, 2005 2005 | 2004 2003 2002 2001 2000 - ------------------------------------------------------------------------------------------------------------------ | - Thousands of Dollars - FIXED CHARGES: | Interest on Long-Term Debt $ 31,437 $ 65,543 | $ 71,743 $ 76,585 $ 65,620 $ 68,678 $ 75,076 Other Interest (1) 1,217 2,078 | 1,414 1,820 273 441 211 Interest on Capital Lease Obligations 39,129 84,912 | 85,869 84,053 87,783 90,506 92,815 - ------------------------------------------------------------------------------------------------------------------ TOTAL FIXED CHARGES 71,783 152,533 | 159,026 162,458 153,676 159,625 168,102 | NET INCOME 7,458 34,773 | 46,127 128,913 55,390 77,778 52,762 | LESS: | Extraordinary Income & Accounting Change - | Net of Tax - - | - 67,471 - 470 - - ------------------------------------------------------------------------------------------------------------------ NET INCOME FROM CONTINUING OPERATIONS 7,458 34,773 | 46,127 61,442 55,390 77,308 52,762 | ADD (DEDUCT): | (Income) Losses from Equity Investees (2) (30) (119)| (131) (76) 17 700 1,543 Income Taxes 6,789 24,690 | 34,815 21,090 36,434 57,545 27,610 Total Fixed Charges 71,783 152,533 | 159,026 162,458 153,676 159,625 168,102 - ------------------------------------------------------------------------------------------------------------------ | TOTAL EARNINGS BEFORE TAXES | AND FIXED CHARGES $ 86,000 $211,877 | $239,837 $244,914 $245,517 $295,178 $250,017 ================================================================================================================== | RATIO OF EARNINGS TO FIXED CHARGES 1.198 1.389 | 1.508 1.508 1.598 1.849 1.487 (1) Excludes recognition of Allowance for Borrowed Funds Used During Construction. (2) Truepricing and Inncom (income) losses.
EX-15 4 exhibit15.txt EXHIBIT 15 - LETTER TO SEC Exhibit 15 August 8, 2005 Securities and Exchange Commission 100 F Street, N.E. Washington, D.C. 20549 Commissioners: We are aware that our report dated August 8, 2005 on our review of interim financial information of UniSource Energy Corporation (the Company) and Tucson Electric Power Company (TEP) for the three and six month periods ended June 30, 2005 and 2004 and included in the Company's quarterly report on Form 10-Q for the quarter ended June 30, 2005 is incorporated by reference in its Registration Statement on Form S-8 (Nos.333-43765, 333-43767, 333-43769, 333-53309, 333-53333, 333-53337, and 333-99317), and on Form S-3 (Nos. 333-31043, 333-93769, and 333-103392). Very truly yours, /s/ PricewaterhouseCoopers LLP PricewaterhouseCoopers LLP Los Angeles, California EX-31 5 exhibit31a.txt EXH. 31(A) - CERT. UNISOURCE (JAMES PIGNATELLI) Exhibit 31(a) CERTIFICATION PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT I, James S. Pignatelli, certify that: 1. I have reviewed the quarterly report on Form 10-Q for the quarter ended June 30, 2005 of UniSource Energy Corporation; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13e-15(f) and 15d-15(f)) for the registrant and have: a. designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b. designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; c. evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this quarterly report based on such evaluation; and d. disclosed in this quarterly report any change in the registrant's internal control over financial reporting that occurred during the registrant's second fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): a. all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b. any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: August 9, 2005 /s/ James S. Pignatelli -------------- ---------------------------------------------------- James S. Pignatelli Chairman, President, and Chief Executive Officer EX-31 6 exhibit31b.txt EXH. 31(B) - CERT. UNISOURCE (KEVIN LARSON) Exhibit 31(b) CERTIFICATION PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT I, Kevin P. Larson, certify that: 1. I have reviewed the quarterly report on Form 10-Q for the quarter ended June 30, 2005 of UniSource Energy Corporation; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13e-15(f) and 15d-15(f)) for the registrant and have: a. designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b. designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; c. evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this quarterly report based on such evaluation; and d. disclosed in this quarterly report any change in the registrant's internal control over financial reporting that occurred during the registrant's second fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): a. all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b. any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: August 9, 2005 /s/ Kevin P. Larson -------------- ---------------------------------------------------- Kevin P. Larson Chief Financial Officer, Vice President and Treasurer EX-31 7 exhibit31c.txt EXH. 31(C) - CERT. TUSCON (JAMES PIGNATELLI) Exhibit 31(c) CERTIFICATION PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT I, James S. Pignatelli, certify that: 1. I have reviewed the quarterly report on Form 10-Q for the quarter ended June 30, 2005 of Tucson Electric Power Company; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: a. designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b. evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this quarterly report based on such evaluation; and c. disclosed in this quarterly report any change in the registrant's internal control over financial reporting that occurred during the registrant's second fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): a. all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b. any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: August 9, 2005 /s/ James S. Pignatelli -------------- ---------------------------------------------------- James S. Pignatelli Chairman, President, and Chief Executive Officer EX-31 8 exhibit31d.txt EXH. 31(D) - CERT. TUSCON (KEVIN LARSON) Exhibit 31(d) CERTIFICATION PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT I, Kevin P. Larson, certify that: 1. I have reviewed the quarterly report on Form 10-Q for the quarter ended June 30, 2005 of Tucson Electric Power Company; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: a. designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b. evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this quarterly report based on such evaluation; and c. disclosed in this quarterly report any change in the registrant's internal control over financial reporting that occurred during the registrant's second fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): a. all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b. any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: August 9, 2005 /s/ Kevin P. Larson -------------- ---------------------------------------------------- Kevin P. Larson Chief Financial Officer, Vice President and Treasurer EX-32 9 exhibit32.txt EXHIBIT 32 - STATEMENT OF CORPORATE OFFICERS Exhibit 32 UNISOURCE ENERGY CORPORATION TUCSON ELECTRIC POWER COMPANY --------------------- STATEMENTS OF CORPORATE OFFICERS (Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002) --------------------- Each of the undersigned, James S. Pignatelli, Chairman of the Board, President and Chief Executive Officer of UniSource Energy Corporation and Tucson Electric Power Company (each a "Company"), and Kevin P. Larson, Vice President, Treasurer and Chief Financial Officer of each Company, hereby certifies, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that each Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 2005, fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, and that the information contained therein fairly presents, in all material respects, the financial condition and results of operations of such Company. August 9, 2005 /s/ James S. Pignatelli ---------------------------------------------------- James S. Pignatelli Chairman of the Board, President and Chief Executive Officer UniSource Energy Corporation Tucson Electric Power Company /s/ Kevin P. Larson ---------------------------------------------------- Kevin P. Larson Vice President, Treasurer and Chief Financial Officer UniSource Energy Corporation Tucson Electric Power Company -----END PRIVACY-ENHANCED MESSAGE-----