-----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, SwmbHp1FxPN1FYfU1Bfj7p/fW10uBfrS8/1omqxYHvFbmkaXnwTnA2jHdI84yiYf rImGeTmRnLztnL+Cgg7EBg== 0000203248-01-500039.txt : 20020410 0000203248-01-500039.hdr.sgml : 20020410 ACCESSION NUMBER: 0000203248-01-500039 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 1 CONFORMED PERIOD OF REPORT: 20010930 FILED AS OF DATE: 20011114 FILER: COMPANY DATA: COMPANY CONFORMED NAME: SOUTHERN UNION CO CENTRAL INDEX KEY: 0000203248 STANDARD INDUSTRIAL CLASSIFICATION: NATURAL GAS DISTRIBUTION [4924] IRS NUMBER: 750571592 STATE OF INCORPORATION: DE FISCAL YEAR END: 0630 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 001-06407 FILM NUMBER: 1786578 BUSINESS ADDRESS: STREET 1: 504 LAVACA ST 8TH FL CITY: AUSTIN STATE: TX ZIP: 78701 BUSINESS PHONE: 5124775852 10-Q 1 fm10q-0102.txt FIRST QUARTER 02 FORM 10-Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D. C. 20549 FORM 10-Q For the quarterly period ended September 30, 2001 Commission File No. 1-6407 SOUTHERN UNION COMPANY (Exact name of registrant as specified in its charter) Delaware 75-0571592 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 504 Lavaca Street, Eighth Floor 78701 Austin, Texas (Zip Code) (Address of principal executive offices) Registrant's telephone number, including area code: (512) 477-5852 Securities Registered Pursuant to Section 12(b) of the Act: Title of each class Name of each exchange in which registered ------------------- ----------------------------------------- Common Stock, par value $1 per share New York Stock Exchange Indicate by check mark whether the 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 ----- ------- The number of shares of the registrant's Common Stock outstanding on November 5, 2001 was 52,145,009. SOUTHERN UNION COMPANY AND SUBSIDIARIES FORM 10-Q September 30, 2001 Index PART I. FINANCIAL INFORMATION Page(s) ------- Item 1. Financial Statements Consolidated statements of operations - three and twelve months ended September 30, 2001 and 2000 2-3 Consolidated balance sheet - September 30, 2001 and 2000 and June 30, 2001 4-5 Consolidated statement of stockholders' equity - three months ended September 30, 2001 and twelve months ended June 30, 2001 6 Consolidated statements of cash flows - three and twelve months ended September 30, 2001 and 2000 7-8 Notes to consolidated financial statements 9-19 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 20-27 Item 3. Quantitative and Qualitative Disclosures about Market Risk 27 PART II. OTHER INFORMATION Item 1. Legal Proceedings (See "COMMITMENTS and CONTINGENCIES" under Notes to Consolidated Financial Statements) 16-19 Item 6. Exhibits and Reports on Form 8-K Reports on Form 8-K Date Filed Description of Filing ---------- -------------------------------------------- 07/17/01 Announcement of "Cash-Flow Improvement Plan" to increase annualized pre-tax cash flow from operations by at least $50 million by the end of fiscal year 2002. 08/09/01 Announcement of operating performance for the quarter and year ended June 30, 2001 and 2000 and filing, under Item 9, summary statements of income of the Company for the quarter and year ended June 30, 2001 and 2000 (unaudited) and notes thereto. - -------------------------------------------------------------------------------- 1 SOUTHERN UNION COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENT OF OPERATIONS Three Months Ended September 30, 2001 2000 ------------ ------------ (thousands of dollars, except shares and per share amounts) Operating revenues.......................... $ 173,969 $ 144,468 Cost of gas and other energy................ (92,987) (84,533) Revenue-related taxes....................... (6,032) (5,079) ------------ ------------ Operating margin......................... 74,950 54,856 Operating expenses: Operating, maintenance and general....... 53,104 37,017 Business restructuring charges........... 32,706 -- Depreciation and amortization............ 21,877 15,966 Taxes, other than on income and revenues.............................. 8,309 4,860 ------------ ------------ Total operating expenses........... 115,996 57,843 ------------ ------------ Net operating loss................. (41,046) (2,987) ------------ ------------ Other income (expenses): Interest ................................ (27,159) (16,306) Dividends on preferred securities of subsidiary trust...................... (2,370) (2,370) Other, net............................... 23,596 (5,513) ------------ ------------ Total other expenses, net.......... (5,933) (24,189) ------------ ------------ Loss before income tax benefit and change in accounting principle.. (46,979) (27,176) Federal and state income tax benefit........ (16,576) (12,600) ------------ ------------ Loss before change in accounting principle.. (30,403) (14,576) Change in accounting principle, net of tax.. -- 602 ------------ ------------ Net loss attributable to common stock....... $ (30,403) $ (13,974) ============ ============ Net loss per share: Basic: Before change in accounting principle. $ (.58) $ (.28) Change in accounting principle, net of tax............................. -- .01 ------------ ------------ $ (.58) $ (.27) ============ ============ Diluted: Before change in accounting principle. $ (.58) $ (.28) Change in accounting principle, net of tax ............................ -- .01 ------------ ------------ $ (.58) $ (.27) ============ ============ Weighted average shares outstanding: Basic................................... 52,424,847 51,018,217 ============ ============ Diluted................................. 52,424,847 51,018,217 ============ ============ See accompanying notes. - -------------------------------------------------------------------------------- 2 SOUTHERN UNION COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENT OF OPERATIONS Twelve Months Ended September 30, 2001 2000 ------------ ------------ (thousands of dollars, except shares and per share amounts) Operating revenues........................ $ 1,962,314 $ 891,387 Cost of gas and other energy.............. (1,383,203) (542,955) Revenue-related taxes..................... (69,755) (36,010) ------------ ------------ Operating margin....................... 509,356 312,422 Operating expenses: Operating, maintenance and general..... 255,639 148,342 Business restructuring charges......... 32,706 -- Depreciation and amortization.......... 89,897 60,257 Taxes, other than on income and revenues............................ 33,309 18,504 ------------ ------------ Total operating expenses......... 414,551 227,103 ------------ ------------ Net operating revenues........... 94,805 85,319 ------------ ------------ Other income (expenses): Interest .............................. (114,372) (59,434) Dividends on preferred securities of subsidiary trust.................... (9,480) (9,480) Other, net............................. 105,928 (14,064) ------------ ------------ Total other expenses, net........ (17,924) (82,978) ------------ ------------ Earnings before income taxes and change in accounting principle..................... 76,881 2,341 Federal and state income taxes............ 36,025 972 ------------ ------------ Earnings before change in accounting principle.............................. 40,856 1,369 Change in accounting principle, net of tax.................................... -- 602 ------------ ------------ Net earnings available for common stock... $ 40,856 $ 1,971 ============ ============ Net earnings per share: Basic: Before change in accounting principle........................ $ .78 $ .03 Change in accounting principle, net of tax........................... -- .01 ------------ ------------ $ .78 $ .04 ============ ============ Diluted: Before change in accounting principle........................ $ .74 $ .03 Change in accounting principle, net of tax .......................... -- .01 ------------ ------------ $ .74 $ .04 ============ ============ Weighted average shares outstanding: Basic.................................. 52,427,252 49,818,381 ============ ============ Diluted................................ 55,469,754 52,063,738 ============ ============ See accompanying notes. - -------------------------------------------------------------------------------- 3 SOUTHERN UNION COMPANY AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET ASSETS September 30, June 30, ----------------------- 2001 2000 2001 ---------- ---------- ---------- (thousands of dollars) Property, plant and equipment: Plant in service.................. $2,201,146 $2,129,828 $2,201,975 Construction work in progress..... 27,523 28,100 25,520 ---------- ---------- ---------- 2,228,669 2,157,928 2,227,495 Less accumulated depreciation and amortization................... (784,713) (732,097) (771,170) ---------- ---------- ---------- Net property, plant and equipment................ 1,443,956 1,425,831 1,456,325 ---------- ---------- ---------- Current assets: Cash and cash equivalents......... -- 2,690 1,219 Accounts receivable, billed and unbilled, net.................. 139,148 109,524 218,912 Inventories, principally at average cost................... 173,729 119,497 106,505 Deferred gas purchase costs....... 65,582 23,849 65,171 Investment securities available for sale....................... 8,052 288,628 29,447 Prepayments and other............. 54,895 33,480 14,778 ---------- ---------- ---------- Total current assets........ 441,406 577,668 436,032 Goodwill, net........................ 721,252 723,971 724,620 Deferred charges..................... 161,315 229,724 209,644 Investment securities, at cost....... 19,226 7,608 19,081 Real estate.......................... 2,474 11,018 2,506 Other................................ 39,267 32,348 41,872 ---------- ---------- ---------- Total............................. $2,828,896 $3,008,168 $2,890,080 ========== ========== ========== See accompanying notes. - -------------------------------------------------------------------------------- 4 SOUTHERN UNION COMPANY AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET (Continued) STOCKHOLDERS' EQUITY AND LIABILITIES September 30, June 30, ----------------------- 2001 2000 2001 ---------- ---------- ---------- (thousands of dollars) Common stockholders' equity: Common stock, $1 par value; authorized 200,000,000 shares; issued 54,667,917 shares....... $ 54,668 $ 51,904 $ 54,553 Premium on capital stock.......... 677,206 625,455 676,324 Less treasury stock, 1,152,036 shares at cost................. (18,055) (15,554) (15,869) Less common stock held in Trust... (18,502) (17,364) (19,196) Deferred compensation plans....... 7,499 858 7,499 Accumulated other comprehensive income......................... (57) 181,257 13,443 Retained earnings (deficit)....... (25,300 (13,974) 5,103 ---------- ---------- ---------- Total common stockholders' equity......................... 677,459 812,582 721,857 Company-obligated mandatorily redeem- able preferred securities of sub- sidiary trust holding solely sub- ordinated notes of Southern Union. 100,000 100,000 100,000 Long-term debt and capital lease obligation........................ 842,866 1,325,105 1,329,631 ---------- ---------- ---------- Total capitalization.............. 1,620,325 2,237,687 2,151,488 Current liabilities: Long-term debt and capital lease obligation due within one year. 490,470 8,004 5,913 Notes payable..................... 193,000 135,453 190,600 Accounts payable.................. 90,025 104,451 103,623 Federal, state and local taxes.... 13,767 7,493 32,342 Accrued interest.................. 16,540 19,654 16,105 Accrued dividends on preferred securities of subsidiary trust. 2,370 2,370 2,370 Customer deposits................. 20,180 21,080 20,285 Other............................. 63,051 67,052 67,383 ---------- ---------- ---------- Total current liabilities...... 889,403 365,557 438,621 ---------- ---------- ---------- Deferred credits and other .......... 126,635 141,870 96,650 Accumulated deferred income taxes.... 192,533 263,054 203,291 Commitments and contingencies........ -- -- -- ---------- ---------- ---------- Total.......................... $2,828,896 $3,008,168 $2,890,080 ========== ========== ========== See accompanying notes. - -------------------------------------------------------------------------------- 5 SOUTHERN UNION COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY Accumu- lated Common Premium Common Other Stock, on Treasury Stock Compre- Retained $1 Par Capital Stock, Held in hensive Earnings/ Value Stock at Cost Trust Income (Deficit) Total ------- -------- --------- --------- ---------- --------- ---------- (thousands of dollars) Balance July 1, 2000...... $50,521 $599,835 $(15,554) $(14,522) $ 115,175 $ -- $ 735,455 Comprehen- sive in- come: Net earn- ings... -- -- -- -- -- 57,285 57,285 Unrea- lized loss in invest- ment secur- ities, net of tax bene- fit.... -- -- -- -- (96,323) -- (96,323) Minimum pension liabil- ity ad- just- ment; net of tax.... -- -- -- -- (4,324) -- (4,324) Cumula- tive effect of change in ac- count- ing prin- ciple, net of tax.... -- -- -- -- 826 -- 826 Unrea- lized loss on hedging activi- ties, net of tax bene- fit.... -- -- -- -- (1,911) -- (1,911) --------- Compre- hen- sive income (loss). (44,447) --------- Payment on note re- ceivable. -- 290 -- -- -- -- 290 Purchase of common stock held in trust.... -- -- -- (4,009) -- -- (4,009) 5% stock dividend. 2,556 49,626 -- -- -- (52,182) -- Benefit plan modifi- cation... -- -- -- 6,560 -- -- 6,560 Issuance of stock for ac- quisi- tion..... 1,371 25,930 -- -- -- -- 27,301 Exercise of stock options.. 105 643 (315) 274 -- -- 707 ------- -------- -------- -------- --------- -------- --------- Balance June 30, 2001...... 54,553 676,324 (15,869) (11,697) 13,443 5,103 721,857 Comprehen- sive in- come: Net loss... -- -- -- -- -- (30,907) (30,403) Unrea- lized loss in invest- ment securi- ties, net of tax.... -- -- -- -- (13,907) -- (13,907) Unrea- lized gain on hedging activi- ties, net of tax.... -- -- -- -- 407 -- 407 --------- Compre- hensive income (loss). (43,903) --------- Purchase of trea- sury stock... -- -- (1,698) -- -- -- (1,698) Stock compen- sation plans... -- 327 -- 372 -- -- 699 Exercise of stock options. 115 555 (488) 322 -- -- 504 ------- -------- -------- -------- --------- -------- --------- Balance Septem- ber 30, 2001...... $54,668 $677,206 $(18,055) $(11,003) $ (57) $(25,300) $ 677,459 ======= ======== ======== ======== ========= ======== ========= See accompanying notes. - -------------------------------------------------------------------------------- 6 SOUTHERN UNION COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS Three Months Ended September 30, 2001 2000 ------------ ------------ (thousands of dollars) Cash flows used in operating activities: Net loss................................. $ (30,403) $ (13,974) Adjustments to reconcile net loss to net cash flows used in operating activities: Depreciation and amortization...... 21,877 15,966 Deferred income taxes.............. 1,476 (1,725) Provision for bad debts............ 1,507 716 Business restructuring charges..... 29,400 -- Gain on sale of gas marketing contracts held by a subsidiary.. (4,653) -- Gain on settlement of interest rate swaps........................... (17,166) -- Financial derivative trading (gain) losses................... (357) 3,195 Change in accounting principle..... -- (602) Other.............................. 135 231 Changes in operating assets and liabilities, net of acquisitions and dispositions: Accounts receivable, billed and unbilled.............. 76,833 (5,398) Accounts payable............. (13,598) (13,212) Taxes and other liabilities.. (18,138) (1,056) Customer deposits............ (105) (357) Deferred gas purchase costs.. (411) (26,554) Inventories.................. (68,108) (44,542) Other........................ 1,068 (7,303) ------------ ------------ Net cash flows used in operating activities...................... (20,643) (94,615) ------------ ------------ Cash flows from (used in) investing activities: Additions to property, plant and equipment.......................... (24,390) (21,908) Acquisition of operations, net of cash received...................... -- (406,830) Proceeds from sale of subsidiaries.... 21,077 -- Proceeds from sale of gas marketing contracts held by a subsidiary..... 4,972 -- Proceeds from settlement of interest rate swaps......................... 17,166 -- Increase (decrease) in customer advances............................ (581) 529 Increase (decrease) in deferred charges and credits................. 2,607 (408) Other.................................. (135) (222) ----------- ------------ Net cash flows from (used in) investing activities............. 20,716 (428,839) ----------- ------------ Cash flows from financing activities: Issuance of long-term debt................ -- 480,000 Issuance cost of debt..................... (290) (2,538) Repayment of debt and capital lease obligation............................. (2,208) (114,706) Net borrowings under revolving credit facility............................... 2,400 135,450 Purchase of treasury stock................ (1,698) -- Other..................................... 504 109 ----------- ------------ Net cash flows from financing activities.......................... (1,292) 498,315 ----------- ------------ Decrease in cash and cash equivalents........ (1,219) (25,139) Cash and cash equivalents at beginning of period.................................... 1,219 27,829 ----------- ------------ Cash and cash equivalents at end of period... $ -- $ 2,690 =========== ============ Supplemental disclosures of cash flow information: Cash paid during the period for: Interest............................ $ 28,311 $ 17,795 =========== ============ Income taxes........................ $ -- $ -- =========== ============ See accompanying notes. - -------------------------------------------------------------------------------- 7 SOUTHERN UNION COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS Twelve Months Ended September 30, 2001 2000 ------------ ------------ (thousands of dollars) Cash flows (used in) from operating activities: Net earnings....................... $ 40,856 $ 1,971 Adjustments to reconcile net earnings to net cash flows from (used in) operating activities: Depreciation and amortiza- tion..................... 92,897 60,257 Deferred income taxes....... 30,979 325 Provision for bad debts..... 33,497 5,194 Business restructuring charges.................. 29,400 -- Gain on sale of investment securities............... (74,582) -- Gain on sale of subsidiary.. (707) -- Gain on sale of gas marketing contracts held by a subsidiary.......... (4,653) -- Gain on sale of real estate. (13,532) -- Gain on settlement of interest rate swaps...... (17,166) -- Financial derivative trading losses........... 2,132 5,431 Change in accounting principle................ -- (602) Other....................... 2,149 1,239 Changes in operating assets and liabilities, net of acquisitions and dispositions: Accounts receivable, billed and unbilled........... (46,944) (18,592) Accounts payable...... (15,330) 20,872 Taxes and other liabilities........ (23,861) 4,977 Customer deposits..... (899) (3,624) Deferred gas purchase costs.............. (41,733) (29,100) Inventories........... (55,111) (33,580) Other................. 1,403 (8,192) ----------- ------------ Net cash flows (used in) from operating activities........... (61,205) 6,576 ----------- ------------ Cash flows used in investing activities: Additions to property, plant and equipment......................... (126,258) (101,936) Acquisition of operations, net of cash received..................... (7,657) (445,196) Proceeds from sale of investment securit........................... 85,761 -- Proceeds from sale of real estate, net of closing costs.............. 20,638 -- Proceeds from sale of subsidiaries... 24,377 -- Proceeds from settlement of interest rate swaps ....................... 17,166 -- Purchase of investment securities.... (12,640) (19,588) Increase in customer advances........ 88 1,044 Increase (decrease) in deferred charges and credits............... (8,907) 458 Proceeds from sale of gas marketing contracts.held by a subsidiary.... 4,972 12,150 Other................................ 5,340 (5,233) ----------- ------------ Net cash flows used in investing activities..................... 2,880 (558,301) ----------- ------------ Cash flows from financing activities: Issuance of long-term debt........... 55,000 780,000 Issuance cost of debt................ (1,226) (9,830) Repayment of debt and capital lease obligation........................ (54,772) (253,002) Premium on early extinguishment of debt.............................. -- (719) Net borrowings under revolving credit facility.......................... 57,547 51,350 Purchase of treasury stock........... (1,698) (14,425) Other................................ 784 445 ----------- ------------ Net cash flows from financing activities..................... 55,635 553,819 ----------- ------------ Change in cash and cash equivalents..... (2,690) 2,094 Cash and cash equivalents at beginning of period............................ 2,690 596 ----------- ------------ Cash and cash equivalents at end of period............................... $ -- $ 2,690 =========== ============ Supplemental disclosures of cash flow information: Cash paid during the period for: Interest....................... $ 118,386 $ 58,076 =========== ============ Income taxes................... $ 21,052 $ 4,321 =========== ============ See accompanying notes. - -------------------------------------------------------------------------------- 8 SOUTHERN UNION COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FINANCIAL STATEMENTS These interim financial statements should be read in conjunction with the financial statements and notes thereto contained in Southern Union Company's (Southern Union and, together with its wholly-owned subsidiaries, the Company) Annual Report on Form 10-K for the fiscal year ended June 30, 2001. Certain prior period amounts have been reclassified to conform with the current period presentation. The interim financial statements are unaudited but, in the opinion of management, reflect all adjustments (including both normal recurring as well as any non-recurring) necessary for a fair presentation of the results of operations for such periods. Because of the seasonal nature of the Company's operations, the results of operations and cash flows for any interim period are not necessarily indicative of results for the full year. As further described below, the Company acquired Providence Energy Corporation and Fall River Gas Company on September 28, 2000, Valley Resources, Inc. on September 20, 2000 and Pennsylvania Enterprises, Inc. on November 4, 1999. Accordingly, the operating activities of the acquired operations are consolidated with the Company beginning on the respective acquisition dates. Thus, the results of operations of the Company for the periods subsequent to the acquisitions are not comparable to those periods prior to the acquisitions nor are the fiscal 2002 results of operations comparable with prior periods. Also, the results of operations for the three- and twelve-month periods ended September 30, 2001 are not indicative of results that would necessarily be achieved for a full year since the majority of the Company's operating margin is earned during the winter heating season. ACQUISITIONS AND DIVESTITURES On September 28, 2000, Southern Union completed the acquisition of Providence Energy Corporation (ProvEnergy) for approximately $270,000,000 in cash plus the assumption of approximately $90,000,000 in long-term debt. The ProvEnergy natural gas distribution operations are Providence Gas and North Attleboro Gas, which collectively serve approximately 177,000 natural gas customers. Providence Gas serves natural gas customers in Providence and Newport, Rhode Island, and 23 other cities and towns in Rhode Island. North Attleboro Gas serves customers in North Attleboro and Plainville, Massachusetts, towns adjacent to the northeastern Rhode Island border. Sub sidiaries of the Company acquired in the ProvEnergy merger include ProvEnergy Oil Enterprises, Inc. (ProvEnergy Oil), and ProvEnergy Power Company, LLC. ProvEnergy Oil, which operated a fuel oil distribution business through its subsidiary, ProvEnergy Fuels, Inc. (ProvEnergy Fuels) for residential and commercial customers in Rhode Island and Massachusetts, was sold for $15,776,000 in August 2001. No gain or loss was recognized on this transaction. ProvEnergy Power Company owns 50% of Capital Center Energy Company, LLC., a joint venture formed between ProvEnergy and ERI Services, Inc. to provide retail power. On September 28, 2000, Southern Union completed the acquisition of Fall River Gas Company (Fall River Gas) for 1,370,629 shares (before adjustment for any subsequent stock dividend) of Southern Union common stock and approximately $27,000,000 in cash plus assumption of approximately $20,000,000 in long-term debt. Fall River Gas serves approximately 49,000 customers in the city of Fall River and the towns of Somerset, Swansea and Westport, all located in southeastern Massachusetts. Also acquired in the Fall River Gas merger was Fall River Gas Appliance Company, Inc., which rents water heaters and conversion burners (primarily for residential use) in Fall River Gas' service area. On September 20, 2000, Southern Union completed the acquisition of Valley Resources, Inc. (Valley Resources) for approximately $125,000,000 in cash plus the assumption of approximately $30,000,000 in long-term debt. Valley Resources natural gas distribution operations are Valley Gas Company and Bristol and Warren Gas Company, which collectively serve approximately 66,000 natural gas customers. Valley Resources' three non-utility subsidiaries acquired in the merger include Valley Appliance and Merchandising Company (VAMCO), Valley Propane, Inc. (Valley Propane) and Morris Merchants, Inc. (Morris Merchants). VAMCO merchandises and rents natural gas burning appliances, offers appliance service contract programs, sells water filtration systems and provides construction - -------------------------------------------------------------------------------- 9 SOUTHERN UNION COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS management services for natural gas-related projects. Valley Propane, which provided liquid propane to customers in Rhode Island and nearby Massachusetts, was sold for $5,301,000 in September 2001. No gain or loss was recognized on this transaction. Morris Merchants, which served as a manufacturers' representative agency for franchised plumbing and heating contract supplies throughout New England and New York was sold for $1,586,000 in October 2001. No gain or loss was recognized on this transaction. Also, acquired in the acquisition was Valley Resources' 90% interest (which is now 100%) in Alternate Energy Corporation, which sells, installs and designs natural gas conversion systems and facilities, is an authorized representative of the ONSI Corporation fuel cell, holds patents for a natural gas/diesel co-firing system and for a device to control the flow of fuel on dual-fuel equipment. The Company funded the cash portion of the above described acquisitions and any related refinancings of assumed debt with a bank note (the Term Note). See Debt and Capital Lease. The assets of ProvEnergy, Fall River Gas and Valley Resources (hereafter referred to as the Company's New England Operations) have been included in the consolidated balance sheet of the Company at September 30, 2001 and the results of operations from the New England Operations have been included in the statement of consolidated operations since their respective acquisition dates. The New England Operations' primary business is the distribution of natural gas through its public utility companies (collectively referred to as the New England Division). The acquisitions were treated as a purchase with related goodwill of approximately $355,000,000. Effective July 1, 2001, goodwill, which was previously amortized on a straight-line basis over forty years, is now accounted for on an impairment-only approach. See Goodwill. The Company plans to sell or dispose of certain non-core businesses acquired in the New England Operations. On November 4, 1999, the Company acquired Pennsylvania Enterprises, Inc. (hereafter referred to as the Pennsylvania Operations) in a transaction valued at approximately $500,000,000, including assumption of long-term debt of approximately $115,000,000. The Company issued approximately 16,700,000 shares (before adjustment for any subsequent stock dividends) of common stock and paid approximately $36,000,000 in cash to complete the transaction. The Company funded the cash portion of the acquisition of the Pennsylvania Operations and related refinancings with the sale of $300,000,000 of 8.25% Senior Notes due 2029 completed on November 3, 1999 (8.25% Senior Notes). See Debt and Capital Lease. The Pennsylvania Operations are headquartered in Wilkes-Barre, Pennsylvania with natural gas distribution being its primary business. The principal operating division of the Pennsylvania Operations is the PG Energy division of the Company which serves more than 156,000 gas customers in northeastern and central Pennsylvania. Subsidiaries of the Company acquired in the acquisition of the Pennsylvania Operations include PG Energy Services Inc., (Energy Services), PEI Power Corporation (PEI Power), Keystone Pipeline Services, Inc. (Keystone, a wholly-owned subsidiary of Energy Services), and Theta Land Corporation. Through Energy Services, the Company supplies propane and offers the inspection, maintenance and servicing of residential and small commercial gas-fired equipment. Through PEI Power, an exempt wholesale generator (within the meaning of the Public Utility Holding Company Act of 1935), the Company provides electricity services to the broad mid-Atlantic market of Pennsylvania, New Jersey, Maryland, Delaware and the District of Columbia. Keystone, which engaged primarily in the construc tion, maintenance, and rehabilitation of natural gas distribution pipelines, was sold for $3,300,000 in June 2001 for a pre-tax gain of $707,000. Theta Land Corporation, which owned and provided land management and development services for more than 44,000 acres of land, was sold for $12,150,000 in January 2000. No gain or loss was recognized on this transaction. In July 2001, the commercial and industrial gas marketing contracts of Energy Services were sold for approximately $4,972,000, resulting in a pre-tax gain of $4,653,000. The Company also plans to sell or dispose of propane operations of Energy Services, which are not material to the Company. The Company has not yet sold these operations and there can be no assurance that a sale on terms satisfactory to the Company will be completed. The assets of the Pennsylvania Operations are included in the consolidated balance sheet of the Company at September 30, 2001 and the results of operations from the Pennsylvania Operations have been included in the statement of consolidated operations since November 4, 1999. The acquisition was treated as a purchase with - -------------------------------------------------------------------------------- 10 SOUTHERN UNION COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS related goodwill of approximately $261,000,000. Effective July 1, 2001, goodwill, which was previously amortized on a straight-line basis over forty years, is now accounted for on an impairment-only approach. See Goodwill. Pro Forma Financial Information The following unaudited pro forma financial information for the three-month periods ended September 30, 2001 and 2000 is presented as though the following events had occurred at the beginning of the earliest period presented: (i) acquisition of the New England Operations; (ii) the issuance of the Term Note; and (iii) the refinancing of certain short-term and long-term debt at the time of the acquisitions. The pro forma financial information is not necessarily indicative of the results which would have actually been obtained had the acquisition of the New England Operations, the issuance of the Term Note, or the refinancings been completed as of the assumed date for the periods presented or which may be obtained in the future. Three Months Ended September 30, 2001 2000 ------------ ------------ Operating revenues.......................... $ 173,969 $ 185,659 Income (loss) before extraordinary item..... (30,403) (35,035) Net earnings (loss) available for common stock.................................... (30,403) (35,035) Net earnings (loss) per common stock: Basic.................................... (.58) (.67) Diluted.................................. (.58) (.67) EARNINGS PER SHARE Average shares outstanding, which excludes treasury stock, for basic earnings per share were 52,424,847 and 51,018,217 for the three-month period ended September 30, 2001 and 2000, respectively, and 52,427,252 and 49,818,381 for the twelve-month period ended September 30, 2001 and 2000, respectively. Diluted earnings per share includes average shares outstanding as well as common stock equivalents from stock options and warrants. Common stock equivalents were nil for both three-month periods ended September 30, 2001 and 2000, respectively, and 1,937,705 and 1,407,824 for the twelve-month periods ended September 30, 2001 and 2000, respectively. At September 30, 2001, 1,127,883 shares of common stock were held by various rabbi trusts for certain of the Company's benefit plans and 61,264 shares were held in a rabbi trust for certain employees who deferred receipt of Company shares for stock options exercised. Subsequent to September 30, 2001, the Company repurchased 1,610,356 shares of its' common stock outstanding at $20.50 per share in private off-market transactions. BUSINESS RESTRUCTURING CHARGES In August 2001, the Company implemented a corporate reorganization and restructuring which was initially announced in July 2001 as part of a Cash Flow Improvement Plan designed to increase annualized pre-tax cash flow from operations by at least $50 million by the end of fiscal year 2002. Actions taken included (i) the offering of voluntary Early Retirement Programs ("ERPs") in certain of its operating divisions and (ii) a limited reduction in force ("RIF") within its corporate offices. ERPs, providing for increased benefits for those electing retirement, were offered to approximately 400 eligible employees across the Company's operating divisions, with approximately 60% of such eligible employees accepting. The RIF was limited solely to certain corporate employees in the Company's Austin and Kansas City offices with forty-eight employees being offered severance packages. In connection with the corporate reorganization and restructuring efforts, the Company recorded a one-time charge of $32,706,000 during the quarter ended September 30, 2001. The charge included $26.5 million of voluntary ERP's, RIF within the corporate offices and employee separation benefits, and $6.2 million connected with various business realignment and restructuring initiatives. The Company expects that most of the restructuring actions will be completed by the end of fiscal year 2002. - -------------------------------------------------------------------------------- 11 SOUTHERN UNION COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS During the first fiscal quarter, the Company paid approximately $0.3 million and $3 million in employee separation and other restructuring costs, respectively. The balance sheet carries a remaining reserve of approximately $29.4 million in estimated reorganization and restructuring expenditures as of September 30, 2001. GOODWILL Effective July 1, 2001, the Company adopted Goodwill and Other Intangible Assets which was issued by the FASB in June 2001. In accordance with this Statement, the Company has ceased amortization of goodwill. Goodwill, which was previously classified on the consolidated balance sheet as additional purchase cost assigned to utility plant and amortized on a straight-line basis over forty years, is now subject to at least an annual assessment for impairment by applying a fair-value based test. The following table reflects the Company's comparative net loss before the change in accounting principle and goodwill amortization under Goodwill and Other Intangible Assets: Three Months Ended September 30, 2001 2000 ------------ ------------ (in thousands, except per share amounts) Reported loss before change in accounting principle................................ $ (30,403) $ (14,576) Goodwill, net of taxes...................... -- 2,605 ------------ ------------ Adjusted net loss before change in accounting principle..................... $ (30,403) $ (11,971) ============ ============ Basic earnings per share: Reported loss before change in accounting principle.................. $ (.58) $ (.28) Goodwill, net of taxes................... -- .05 ------------ ------------ Adjusted net loss before change in accounting principle.................. $ (.58) $ (.23) ============ ============ Diluted earnings per share: Reported loss before change in accounting principle.................. $ (.58) $ (.28) Goodwill, net of taxes................... -- .05 ------------ ------------ Adjusted net loss before change in accounting principle.................. $ (.58) $ (.23) ============ ============ The following displays changes in the carrying amount of goodwill for the quarter ended September 30, 2001: Total --------- Balance as of July 1, 2001......................................... $724,620 Impairment losses.................................................. (3,358) Other.............................................................. (10) -------- Balance as of September 30, 2001................................... $721,252 ======== In connection with the Company's Cash Flow Improvement Plan announced in July 2001, the Company began the divestiture of certain non-core subsidiaries and assets. As a result of prices of comparable businesses for various non-core properties, a goodwill impairment loss of $3,358,000 was recognized in depreciation and amortization on the consolidated statement of operations for the quarter ended September 30, 2001. - -------------------------------------------------------------------------------- 12 SOUTHERN UNION COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS INVESTMENT SECURITIES At September 30, 2001, the Company held securities of Capstone Turbine Corporation (Capstone). This investment is classified as "available for sale" under the Financial Accounting Standards Board Standard Accounting for Certain Investments in Debt and Equity Securities. As of September 30, 2001, the Company's investment in Capstone had a fair value of $8,052,000 and unrealized gains, net of tax, related to this investment were $4,945,000. The Company has classified this investment as current, as it plans to monetize its investment as soon as practicable and use the proceeds to reduce outstanding debt. All other securities owned by the Company are accounted for under the cost method. The Company's other invest ments in securities consist primarily of preferred stock in non-public companies whose value is not readily determinable. OTHER INCOME During the quarter ended September 30, 2001, the Company negotiated three interest rate swaps that were not designated as hedges and did not meet the criteria for hedge accounting. The first swap, effective July 5, 2001, carried a notional amount of $100,000,000 and termination of June 30, 2005. The remaining swaps, effective July 23, 2001 and August 1, 2001, carried notional amounts of $300,000,000 and $200,000,000, respectively, with terminations of November 15, 2004 and February 1, 2005, respectively. On September 19, 2001, these interest rate swaps were settled, resulting in a pre-tax gain and cash flow of $17,166,000. DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES Derivative Instruments and Hedging Activities The Company utilizes derivative instruments on a limited basis to manage certain business risks. Interest rate swaps are employed to hedge the effect of changes in interest rates related to certain debt instruments and commodity swaps and options to manage price risk associated with certain energy contracts. In accordance with adoption of this Statement on July 1, 2000, the Company recorded a net-of-tax cumulative-effect gain of $602,000 in earnings to recognize the fair value of the gas derivative contracts at PG Energy Services, Inc., a wholly-owned subsidiary, that are not designated as hedges. The Company also recorded $826,000 in accumulated other comprehensive income which recognizes the fair value of two interest rate swap derivatives that were designated as cash flow hedges. Cash Flow Hedges The Company manages exposure against volatility in interest payments on variable rate debt through interest rate swaps. As of September 30, 2001, $866,000 in after-tax comprehensive income generated through the expiration of one interest rate swap was partially offset by the fair value of the Company's remaining obligation under two interest rate swaps which resulted in $459,000 of unrealized losses, net of tax. During the first quarter of fiscal year 2002, the Company recorded net settlement payments of $916,000 on these derivatives through interest expense. The Company expects to reclassify as interest expense $678,000 in derivative losses, net of taxes, from accumulated other comprehensive income as the settlement of swap payments occur over the next twelve months. The maximum term over which the Company is hedging exposures to the variability of cash flows is 25 months. Trading Contracts In March 2001, the Company discovered unauthorized financial derivative energy trading activity by a non-regulated, wholly-owned subsidiary. All unauthorized trading activity was subsequently closed in March and April of 2001 resulting in a cumulative cash expense of $191,000, net of taxes. During the quarter ended September 30, 2001, the Company recorded expiration of contracts resulting from this trading activity through other income, generating $221,000 in earnings, after taxes. The majority of the remaining deferred liability of $7,219,000 - -------------------------------------------------------------------------------- 13 SOUTHERN UNION COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS at September 30, 2001 related to these derivative instruments will be recognized as income in the Consolidated Statement of Operations over the next four years based on the related contracts. Beginning in May 2001, the Company acquired natural gas commodity swap derivatives and collar transactions in order to mitigate price volatility of natural gas passed through to utility customers. The cost of the derivative products and the settlement of the respective obligations are recorded through the gas purchase adjustment clause as authorized by the applicable regulatory authority and therefore do not impact earnings. As of September 30, 2001, the fair value of the contracts, which expire at various times through May 2002, are included in the consolidated financial statements as a liability and a matching adjustment to deferred cost of gas of $5,068,000. PREFERRED SECURITIES OF SUBSIDIARY TRUST On May 17, 1995, Southern Union Financing I (Subsidiary Trust), a consolidated wholly-owned subsidiary of Southern Union, issued $100,000,000 of 9.48% Trust Originated Preferred Securities (Preferred Securities). In connection with the Subsidiary Trust's issuance of the Preferred Securities and the related purchase by Southern Union of all of the Subsidiary Trust's common securities (Common Securities), Southern Union issued to the Subsidiary Trust $103,092,800 principal amount of its 9.48% Subordinated Deferrable Interest Notes, due 2025 (Subordinated Notes). The sole assets of the Subsidiary Trust are the Subordinated Notes. The interest and other payment dates on the Subordinated Notes correspond to the distribution and other payment dates on the Preferred Securities and the Common Securities. Under certain circumstances, the Subordinated Notes may be distributed to holders of the Preferred Securities and holders of the Common Securities in liquidation of the Subsidiary Trust. The Subordinated Notes are redeemable at the option of the Company on or after May 17, 2000, at a redemption price of $25 per Subordinated Note plus accrued and unpaid interest. The Preferred Securities and the Common Securities will be redeemed on a pro rata basis to the same extent as the Subordinated Notes are repaid, at $25 per Preferred Security and Common Security plus accumulated and unpaid distributions. Southern Union's obligations under the Subordi nated Notes and related agreements, taken together, constitute a full and unconditional guarantee by Southern Union of payments due on the Preferred Securities. As of September 30, 2001 and 2000, 4,000,000 shares of Preferred Securities were outstanding. DEBT AND CAPITAL LEASE September 30, June 30, 2001 2001 ------------- ------------ (thousands of dollars) 7.60% Senior Notes due 2024..................... $ 364,515 $ 364,515 8.25% Senior Notes due 2029..................... 300,000 300,000 Term Note, due 2002............................. 485,000 485,000 5.62% to 10.25% First Mortgage Bonds, due 2002 to 2029...................................... 150,482 150,815 7.70% Debentures, due 2027...................... 6,801 6,806 Capital lease and other......................... 26,535 28,408 ------------- ------------ Total debt and capital lease.................... 1,333,336 1,335,544 Less current portion........................ 490,470 5,913 ------------- ------------ Total long-term debt and capital lease.......... $ 842,866 $ 1,329,631 ============= ============ Senior Notes On November 3, 1999, the Company completed the sale of $300,000,000 of 8.25% Senior Notes (8.25% Notes) due 2029. The net proceeds from the sale of these 8.25% Notes were used to: (i) fund the acquisition of Pennsylvania Enterprises, Inc.; (ii) repay approximately $109,900,000 of borrowings under the revolving credit facility, and (iii) repay approximately $136,000,000 of long- and short-term debt assumed in the acquisition. - -------------------------------------------------------------------------------- 14 SOUTHERN UNION COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Assumed Debt In connection with the acquisition of the Pennsylvania Operations, the Company assumed $45,000,000 of First Mortgage Bonds bearing interest between 8.375% and 9.34%. In connection with the acquisition of ProvEnergy, the Company assumed $86,916,000 of First Mortgage Bonds bearing interest between 5.62% and 10.25%. In connection with the acquisition of Fall River Gas, the Company assumed $19,500,000 of First Mortgage Bonds bearing interest between 7.24% and 9.44%. In connection with the acquisition of Valley Resources, the Company assumed $6,905,000 of 7.70% Debentures. Capital Lease The Company completed the installation of an Automated Meter Reading (AMR) system at Missouri Gas Energy during the first quarter of fiscal year 1999. The installation of the AMR system involved an investment of approximately $30,000,000 which is accounted for as a capital lease obligation. As of September 30, 2001, the capital lease obligation outstanding was $22,706,000 ith a fixed rate of 5.79%. This system has significantly improved meter reading accuracy and timeliness and provided electronic accessibility to meters in residential customers' basements, thereby assisting in the reduction of the number of estimated bills. Credit Facilities On May 29, 2001, the Company restated and amended its short-term and long-term credit facilities (together referred to as "Revolving Credit Facilities"). The Company has available $150,000,000 under the short- term facility, which expires May 28,2002, and $225,000,000 under the long-term facility, which expires on May 29, 2004. The Company has additional availability under uncommitted line of credit facilities with various banks. Borrowings under the Revolving Credit Facilities are available for Southern Union's working capital, letter of credit requirements and other general corporate purposes. A balance of $193,000,000 was outstanding under the facilities at September 30, 2001. Term Note On August 28, 2000 the Company entered into the Term Note to fund (i) the cash portion of the con sideration to be paid to the Fall River Gas' stockholders; (ii) the all cash consideration to be paid to the ProvEnergy and Valley Resources stockholders, (iii) repayment of approximately $50,000,000 of long- and short-term debt assumed in the mergers, and (iv) all related acquisition costs. As of September 30, 2001, a balance of $485,000,000 was outstanding under this Term Note. The Term Note, which initially expired on August 27, 2001, has been extended through August 26, 2002 for a fee. No additional draws can be made on the Term Note. UTILITY REGULATION AND RATES Missouri On July 5, 2001, the Missouri Public Service Commission (MPSC) issued an order approving a unanimous settlement of Missouri Gas Energy's rate request. The settlement provides for an annual $9,892,000 base rate increase, as well as $1,081,000 in added revenue from new and revised service charges. The majority of the rate increase will be recovered through increased monthly fixed charges to gas sales service customers. New rates became effective August 6, 2001, two months before the statutory deadline for resolving the case. The approved settlement requires parties to seek dismissal of all pending judicial reviews of prior rate cases. The settlement also provides for the development of a two-year experimental low-income program that will help certain customers in the Joplin area pay their natural gas bills. New England Division On November 1, 2001, the New England Division of Southern Union Company submitted a comprehensive filing with the Rhode Island Public Utilities Commission (RIPUC) to implement a "One State; One Rate" simplified and uniform rate structure. Such filing reflects the consolidated operations of the various gas distribution operations in Rhode Island and fulfills the terms of a settlement agreement associated with the merger of the Companies in Docket Nos. D-00-2 and D-00-3. The filing includes: merger-related savings; technology investments over a five-year period; a commitment to developing Service Quality Standards in collaboration with state regulators; a "community reinvestment program"; and expansion of eligibility in the Business Choice program. The proposed rates would increase annual operating revenues by $7.2 million or 3%, with individual customer impacts varying as a result of the rate schedule - -------------------------------------------------------------------------------- 15 SOUTHERN UNION COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS consolidation and restructuring. Other changes incorporated in the filing include: separation of distribution charges from cost of gas charges; switching from billing on the basis of the volumetric measure Ccf (hundred cubic feet) to energy consumption (therms); customer- and company-sharing of any incremental merger-related savings; and introduction of a weather adjustment to customer bills. The New England Division has requested that the new rate schedules take effect on December 1, 2001. However, no rate change will take effect until the RIPUC has conducted a full investigation on the proposed rate restructuring and increase and actual implementation of changes is not expected until July 1, 2002. Pennsylvania On April 3, 2000, PG Energy filed an application with the Pennsylvania Public Utility Commission (PPUC) seeking an increase in its base rates designed to produce $17,900,000 in additional annual revenues. On December 7, 2000, the PPUC approved a settlement agreement that provided for a rate increase designed to produce $10,800,000 of additional annual revenue. The new rates became effective on January 1, 2001. El Paso, Texas On October 18, 1999, Southern Union Gas filed a $1,696,000 rate increase request for the El Paso service area with the City of El Paso. In February 2000, the City of El Paso approved a $650,000 revenue increase, and an improved rate design that collects a greater portion of the Company's revenue stream from the monthly customer charge. Additionally, the City of El Paso approved a new 30-year franchise for Southern Union Gas. COMMITMENTS AND CONTINGENCIES Environmental The Company is subject to federal, state and local laws and regulations relating to the protection of the environment. These evolving laws and regulations may require expenditures over a long period of time to control environmental impacts. The Company has established procedures for the on-going evaluation of its operations to identify potential environmental exposures and assure compliance with regulatory policies and procedures. The Company is investigating the possibility that the Company or predecessor companies may have been associated with Manufactured Gas Plant (MGP) sites in its former service territories, principally in Arizona and New Mexico, and present service territories in Texas, Missouri, Pennsylvania, Massachusetts and Rhode Island. At the present time, the Company is aware of certain MGP sites in these areas and is investigating those and certain other locations. While the Company's evaluation of these Texas, Missouri, Arizona, New Mexico, Pennsylvania, Massachusetts and Rhode Island MGP sites is in its preliminary stages, it is likely that some compliance costs may be identified and become subject to reasonable quantification. Within the Company's service territories certain MGP sites are currently the subject of governmental actions. These sites are as follows: Kansas City, Missouri MGP Sites In a letter dated May 10, 1999, the Missouri Department of Natural Resources (MDNR) sent notice of a planned Site Inspection/Removal Site Evaluation of the Kansas City Coal Gas Former Manufactured Gas Plant site. This site (comprised of two adjacent MGP operations previously owned by two separate companies and hereafter referred to as Station A and Station B) is located at East 1st Street and Campbell in Kansas City, Missouri and is owned by Missouri Gas Energy (MGE). A 1988 investigation of the site performed by an Environmental Protection Agency (EPA) contractor determined that further remedial assessment was not required under the Comprehensive Environmental Response, Compensation and Liability Act of 1980 (CERCLA), as amended by the SUPERFUND Amendments and Reauthorization Act of 1986. The MDNR has stated that the reassessment of the Kansas City Coal Gas site is part of a statewide effort to identify, evaluate, and prioritize the potential hazards posed by all of Missouri's MGP sites. During July 1999, the Company sent applications to MDNR submitting the two sites to the agency's Voluntary Cleanup Program (VCP). The sites were accepted into the VCP on August 2, 1999 and MGE subsequently performed environmental assessments at the sites and submitted assessment results to MDNR on March 6, 2000. In a letter dated June 21, 2000, MDNR responded to the Station A environmental report submitted by the Company. In that letter, MDNR stated that soil remediation will be - -------------------------------------------------------------------------------- 16 SOUTHERN UNION COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS necessary at the site (Station A) but that further exploration and delineation of site contamination should be performed before remedial methods can be determined. MGE performed additional assessment work in accordance with MDNR's request. In a letter dated May 7, 2001, MDNR responded to the Station B environmental report. That letter suggested that some soils would need to be remediated, but that certain areas on Station B require further investigation to determine whether significant contamination exists. North of the Kansas City, Missouri Station A and B MGP sites, the City of Kansas City Port Authority ("Port Authority") is developing a parcel of land adjacent to the Missouri River and known as the "Riverfront Development." In the course of developing this property, the Port Authority entered the Riverfront Development into the Missouri Voluntary Cleanup Program. In a letter dated April 23, 2001, MDNR invited representatives of MGE, the Port Authority and Honeywell International Inc. (the alleged successor to Barrett Manufacturing Company, a tar manufacturer formerly located on a portion of the Riverfront Development) to a technical meeting to discuss the investigation, cleanup, closure and redevelopment of the Riverfront Development and MGE's properties. That meeting was held on May 16, 2001. On July 18, 2001, representatives of MGE and the Port Authority met to discuss MGE's proposal for a limited assessment and remediation of a portion of the Port Authority property allegedly impacted by the historic MGP. That proposal was set forth in a letter from MGE to the Port Authority dated July 31, 2001. In a letter dated July 27, 2001, Honeywell International Inc. proposed to the Port Authority that Honeywell perform a similar assessment on the portion of the Riverfront Development formerly occupied by Barrett Manufacturing Company. In a letter addressed to MGE and dated August 3, 2001, the Port Authority set forth its demand that MGE assume responsibility for the remediation of soil and groundwater at the Riverfront Development, and in a letter dated August 15, 2001, the Port Authority granted a conditional acceptance of MGE's proposal for MGE's limited assessment of the Riverfront Development. In September and October 2001, Honeywell and MGE each performed assessments of its proposed portion of the Port Authority property. Results of these assessments will be presented to the Port Authority in November 2001. Providence, Rhode Island Sites During 1995, Providence Gas began an environmental evaluation at its primary gas distribution facility located at 642 Allens Avenue in Providence, Rhode Island. Environmental studies and a subsequent remediation work plan were completed at an approximate cost of $4.5 million. Providence Gas also began a soil remediation project on a portion of the site in July 1999. As of June 30, 2001, approximately $8,900,000 had been expended on soil remediation under the remediation work plan. Based on the results of the environmental investigation and the site information learned during the performance of work under the remediation work plan, the Company submitted a revised remedial action work plan ("RAWP") for the site to the Rhode Island Department of Environmental Management ("RIDEM") on July 24, 2001. Following RIDEM's rejection of Providence Gas' revised RAWP, a meeting was held on October 9, 2001 with representatives of RIDEM, in which representatives of Providence Gas agreed to submit a revised request, narrowed in scope, to RIDEM. Although additional remediation work is planned for the site during calendar year 2002, assessment and remediation costs will not exceed $500,000 during calendar year 2001. Because the Company has not reached agreement with RIDEM on the terms of the revised RAWP, the Company cannot offer any conclusions as to the total future cost of remediation of the property at this time. However, one estimate of the cost of the environmental work proposed under the revised RAWP is $5,700,000. In November 1998, Providence Gas received a letter of responsibility from the RIDEM relating to possible contamination on previously owned property at 170 Allens Avenue in Providence. The current operator of the property has also received a letter of responsibility. A work plan had been created and approved by RIDEM. An investigation was then begun to determine the extent of contamination, as well as the extent of the Company's responsibility. Providence Gas entered into a cost-sharing agreement with the current operator of the property, under which Providence Gas was responsible for approximately twenty percent (20%) of the costs related to the investiga tion. Costs of testing at this site as of June 30, 2001 were approximately $300,000. Until the results of the investigation are known, the Company cannot offer any conclusions as to its responsibility. - -------------------------------------------------------------------------------- 17 SOUTHERN UNION COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Tiverton, Rhode Island Site Fall River Gas Company is a defendant in a civil action seeking to recover anticipated remediation costs associated with contamination found at property owned by the plaintiffs. This claim is based on alleged dumping of material by Fall River Gas Company trucks at the site in the 1930s and 1940s. Valley Gas Company Sites Valley Gas Company is a party to an action in which Blackstone Valley Electric Company ("Blackstone") brought suit for contribution to its expenses of cleanup of a site on Mendon Road in Attleboro, Massachusetts, to which coal manufacturing waste was transported from a former MGP site in Pawtucket, Rhode Island (the "Blackstone Litigation"). Blackstone Valley Electric Company v. Stone & Webster, Inc., Stone & Webster Engineering Corporation, Stone & Webster Management Consultants, Inc. and Valley Gas Company, C. A. No. 94-10178JLT, United States District Court, District of Massachusetts. Valley Gas Company takes the position in that litigation that it is indemnified for any cleanup expenses by Blackstone pursuant to a 1961 agreement signed at the time of Valley Gas Company's creation. This suit was stayed in 1995 pending the issuance of rulemaking at the United States EPA (Commonwealth of Massachusetts v. Blackstone Valley Electric Company, 67 F.3d 981 (1995)). In January 2001, the EPA issued a Preliminary Administrative Decision on this issue and announced that it was soliciting comments on the Decision. While the public comment period has now closed, the EPA has yet to reissue its decision. While this suit has been stayed, Valley Gas Company and Blackstone (merged with Narragansett Electric Company in May 2000) have received letters of responsibility from the RIDEM with respect to releases from two MGP sites in Rhode Island. RIDEM issued letters of responsibility to Valley Gas Company and Blackstone in September 1995 for the Tidewater MGP in Pawtucket, Rhode Island, and in February 1997 for the Hamlet Avenue MGP in Woonsocket, Rhode Island. Valley Gas Company entered into an agreement with Blackstone (now Narragansett) in which Valley Gas Company and Blackstone agreed to share equally the expenses for the costs associated with the Tidewater site subject to reallocation upon final determination of the legal issues that exist between the companies with respect to responsibility for expenses for the Tidewater site and otherwise. No such agreement has been reached with respect to the Hamlet site. To the extent that potential costs associated with former MGPs are quantified, the Company expects to provide any appropriate accruals and seek recovery for such remediation costs through all appropriate means, including in rates charged to customers, insurance and regulatory relief. At the time of the closing of the acquisition of the Company's Missouri service territories, the Company entered into an Environmental Liability Agreement that provides that Western Resources retains financial responsibility for certain liabilities under environmental laws that may exist or arise with respect to Missouri Gas Energy. In addition, at the time it was acquired, Providence Gas had in place a regulatory plan that created a mechanism for the recovery of environmental-related costs. This plan provided for recovery of environmental investigation and remediation costs incurred through September 30, 1997, as well as costs incurred during the three-year term of the plan, are to be amortized over a 10-year period, at a level authorized under the plan. A new plan, effective October 1, 2000 through June 30, 2002, establishes an environmental fund for the recovery of evaluation, remedial and clean-up costs arising out of the Company's MGPs and sites associated with the operation and disposal activities from MGPs. Although significant charges to earnings could be required prior to rate recovery, management does not believe that environmental expenditures for MGP sites will have a material adverse effect on the Company's financial position, results of operations or cash flows. The Company follows the provisions of an American Institute of Certified Public Accountants Statement of Position, Environmental Remediation Liabilities, for recognition, measurement, display and disclosure of environmental remediation liabilities. Southwest Gas Litigation On February 1, 1999, Southern Union submitted a proposal to the Board of Directors of Southwest Gas Corporation (Southwest) to acquire all of Southwest's outstanding common stock for $32.00 per share. Southwest at that time had a pending merger agreement with ONEOK, Inc. (ONEOK) at $28.50 per share, executed on December 14, 1998. On February 22, 1999, Southern Union and Southwest both publicly announced - -------------------------------------------------------------------------------- 18 SOUTHERN UNION COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Southern Union's proposal, after the Southwest Board of Directors determined that Southern Union's proposal was a Superior Proposal (as defined in the Southwest merger agreement with ONEOK). At that time Southern Union entered into a Confidentiality and Standstill Agreement with Southwest at Southwest's insistence. On April 25, 1999, Southwest's Board of Directors rejected Southern Union's $32.00 per share offer and accepted an amended offer of $30.00 per share from ONEOK. On April 27, 1999, Southern Union increased its offer to $33.50 per share and agreed to pay interest which, together with dividends, would provide Southwest shareholders with a 6% annual rate of return on its $33.50 offer, commencing February 15, 2000, until closing. Southern Union's revised proposal was rejected by Southwest's Board of Directors. On January 21, 2000, ONEOK announced that it was withdrawing from the Southwest merger agreement. There are several lawsuits pending that relate to activities surrounding Southern Union's efforts to acquire Southwest. Southern Union intends to vigorously pursue its claims against Southwest, ONEOK, and certain individual defendants, and vigorously defend itself against the claims by Southwest and ONEOK. The Company believes that the results of the above-noted Southwest Gas litigation will not have a materially adverse effect on the Company's financial condition, results of operations or cash flows. Regulatory In August 1998, a jury in Edinburg, Texas concluded deliberations on the City of Edinburg's franchise fee lawsuit against PG&E Gas Transmission, Texas Corporation (formerly Valero Energy Corporation (Valero)) and a number of its subsidiaries, as well as former Valero subsidiary Rio Grande Valley Gas Company (RGV) and RGV's successor company, Southern Union Company. Southern Union purchased RGV from Valero in October 1993. The jury awarded the plaintiff damages, against all defendants under several largely overlapping but mutually exclusive claims, totaling approximately $13,000,000. The trial judge subsequently reduced the award to approximately $700,000 against Southern Union and $7,800,000 against Valero and Southern Union together. The trial court's decision was appealed to the Thirteenth District of the Texas Court of Appeals (Court of Appeals). In December 2000, the Court of Appeals reversed and modified the trial court's judgment of approximately $8,500,000 and awarded the City of Edinburg $585,000, plus pre-judgment interest of $190,000 against RGV and Valero for breach of contract. The Court of Appeals upheld the award for attorneys' fees of approximately $3,500,000 against Valero, RGV and Southern Union. In subsequent decisions, the Court of Appeals first excluded Southern Union from, then reinstated against Southern Union, the December 2000 judgment. The Court of Appeals also remanded a portion of the case to the Trial Court with instructions to retry certain issues. The Company will continue to pursue reversal on appeal. The Company believes that the outcome of this matter will not have a material adverse impact on the Company's results of operations, financial position or cash flows. The Company also has entered into a settlement agreement to settle a related class action lawsuit with a majority of the cities served by the Company in Texas. The settlement will not have a material adverse impact on the Company's results of operations, financial position or cash flows. Other Southern Union and its subsidiaries are parties to other legal proceedings that management considers to be normal actions to which an enterprise of its size and nature might be subject, and not to be material to the Company's overall business or financial condition, results of operations or cash flows. - -------------------------------------------------------------------------------- 19 SOUTHERN UNION COMPANY AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview The Company's core business is the distribution of natural gas as a public utility through: Southern Union Gas, Missouri Gas Energy (MGE); PG Energy; Atlantic Utilities, doing business as South Florida Natural Gas (SFNG); and, effective with the September 2000 acquisitions of Providence Energy Corporation, Valley Resources, Inc. and Fall River Gas Company, its New England Division. In addition, subsidiaries of Southern Union support and expand natural gas sales and to capitalize on the Company's gas energy expertise. These subsidiaries operate natural gas pipeline systems, generate electricity, market natural gas to end-users and distribute propane. Certain subsidiaries also own or hold interests in real estate and other assets, which are primarily used in the Company's utility business. Several of these business activities are subject to regulation by federal, state or local authorities where the Company operates. Thus, the Company's financial condition and results of operations have been and will continue to be dependent upon the receipt of adequate and timely adjustments in rates. In addition, the Company's business is affected by seasonal weather impacts, competitive factors within the energy industry and economic development and residential growth in its service areas. Acquisitions and Divestitures On September 28, 2000, Southern Union completed the acquisition of Providence Energy Corporation (ProvEnergy) for approximately $270,000,000 in cash plus the assumption of approximately $90,000,000 in long-term debt. The ProvEnergy natural gas distribution operations are Providence Gas and North Attleboro Gas, which collectively serve approximately 177,000 natural gas customers. Providence Gas serves natural gas customers in Providence and Newport, Rhode Island, and 23 other cities and towns in Rhode Island. North Attleboro Gas serves customers in North Attleboro and Plainville, Massachusetts, towns adjacent to the northeastern Rhode Island border. Subsidiaries of the Company acquired in the ProvEnergy merger include ProvEnergy Oil Enterprises, Inc. (ProvEnergy Oil), and ProvEnergy Power Company, LLC. ProvEnergy Oil, which operated a fuel oil distribution business through its subsidiary, ProvEnergy Fuels, Inc. (ProvEnergy Fuels) for residential and commercial customers in Rhode Island and Massachusetts, was sold for $15,776,000 in August 2001. No gain or loss was recognized on this transaction. ProvEnergy Power Company owns 50% of Capital Center Energy Company, LLC., a joint venture formed between ProvEnergy and ERI Services, Inc. to provide retail power. On September 28, 2000, Southern Union completed the acquisition of Fall River Gas Company (Fall River Gas) for 1,370,629 shares (before adjustment for any subsequent stock dividend) of Southern Union common stock and approximately $27,000,000 in cash plus assumption of approximately $20,000,000 in long-term debt. Fall River Gas serves approximately 49,000 customers in the city of Fall River and the towns of Somerset, Swansea and Westport, all located in southeastern Massachusetts. Also acquired in the Fall River Gas merger was Fall River Gas Appliance Company, Inc., which rents water heaters and conversion burners (primarily for residential use) in Fall River Gas' service area. On September 20, 2000, Southern Union completed the acquisition of Valley Resources, Inc. (Valley Resources) for approximately $125,000,000 in cash plus the assumption of approximately $30,000,000 in long-term debt. Valley Resources natural gas distribution operations are Valley Gas Company and Bristol and Warren Gas Company, which collectively serve approximately 66,000 natural gas customers. Valley Resources' three non-utility subsidiaries acquired in the merger include Valley Appliance and Merchandising Company (VAMCO), Valley Propane Inc. (Valley Propane) and Morris Merchants, Inc. (Morris Merchants). VAMCO merchandises and rents natural gas burning appliances, offers appliance service contract programs, sells water filtration systems and provides construction management services for natural gas-related projects. Valley Propane, which provided liquid propane to customers in Rhode Island and nearby Massachusetts, was sold for $5,301,000 in September 2001. No gain or loss was recognized on this transaction. Morris Merchants, which served as a manufacturers' representative agency for franchised plumbing and heating contract supplies throughout New England and New York was sold for $1,586,000 in October 2001. No gain or loss was recognized on this transaction. Also acquired in the acquisition was Valley Resources' 90% interest (which is now 100%) in Alternate Energy Corporation, which sells, installs and designs - -------------------------------------------------------------------------------- 20 SOUTHERN UNION COMPANY AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS natural gas conversion systems and facilities, is an authorized representative of the ONSI Corporation fuel cell, holds patents for a natural gas/diesel co-firing system and for a device to control the flow of fuel on dual-fuel equipment. Collectively, the operations from the above-mentioned acquisitions are referred to as the New England Operations. The Company plans to sell or dispose of certain non-core businesses acquired in the New England Operations. On November 4, 1999, the Company acquired Pennsylvania Enterprises, Inc. (hereafter referred to as the Pennsylvania Operations) in a transaction valued at approximately $500,000,000, including assumption of long-term debt of approximately $115,000,000. The Company issued approximately 16,700,000 shares (before adjustment for any subsequent stock dividends) of common stock and paid approximately $36,000,000 in cash to complete the transaction. The Pennsylvania Operations are headquartered in Wilkes-Barre, Pennsylvania with natural gas distribution being its primary business. The principal operating division of the Pennsylvania Operations is the PG Energy division of the Company which serves more than 156,000 gas customers in northeastern and central Pennsylvania. Subsidiaries of the Company acquired in the acquisition of the Pennsylvania Operations include PG Energy Services Inc., (Energy Services), PEI Power Corporation (PEI Power), Keystone Pipeline Services, Inc. (Keystone, a wholly-owned subsidiary of Energy Services), and Theta Land Corporation. Through Energy Services, the Company supplies propane and offers the inspection, maintenance and servicing of residential and small commercial gas-fired equipment. Through PEI Power, an exempt wholesale generator (within the meaning of the Public Utility Holding Company Act of 1935), the Company provides electricity services to the broad mid-Atlantic market of Pennsylvania, New Jersey, Maryland, Delaware and the District of Columbia. Keystone, which engaged primarily in the construction, maintenance, and rehabilitation of natural gas distribution pipelines, was sold for $3,300,000 in June 2001 for a pre-tax gain of $707,000. Theta Land Corporation, which owned and provided land management and development services for more than 44,000 acres of land, was sold for $12,150,000 in January 2000. No gain or loss was recognized on this transaction. In July 2001, the commercial and industrial gas marketing contracts of Energy Services were sold for approximately $4,972,000, resulting in a pre-tax gain of $4,653,000. The Company also plans to sell or dispose of propane operations of Energy Services, which are not material to the Company. The Company has not yet sold these operations and there can be no assurance that a sale on terms satisfactory to the Company will be completed. The operating activities of the acquired operations are consolidated with the Company beginning on their respective acquisition dates. Thus, the results of operations for the three- and twelve-month periods ended September 30, 2001 are not indicative of results that would necessarily be achieved for a full year since the majority of the Company's operating margin is earned during the winter heating season. For these reasons, the results of operations of the Company for the periods subsequent to the acquisitions are not comparable to those periods prior to the acquisitions nor are the fiscal 2002 results of operations comparable with prior periods. RESULTS OF OPERATIONS Three Months Ended September 30, 2001 and 2000 The Company recorded a net loss attributable to common stock of $30,403,000 for the three-month period ended September 30, 2001 compared with a net loss of $13,974,000 for the three-month period ended September 30, 2000. Net loss per common share, based on weighted average shares outstanding during the period, was $.58 in 2001 compared with a net loss per common share of $.27 in 2000. The current quarter net loss was principally impacted by a pre-tax charge for business restructuring of $32,706,000 ($.39 per basic and diluted share). Due to the seasonal nature of the gas utility business, the three-month period ending September 30 is typically a loss period. - -------------------------------------------------------------------------------- 21 SOUTHERN UNION COMPANY AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Operating revenues were $173,969,000 for the three-month period ended September 30, 2001, compared with operating revenues of $144,468,000 in 2000. Gas purchase and other energy costs for the three-month period ended September 30, 2001 were $92,987,000, compared with $84,533,000 in 2000. The Company's operating revenues are affected by the level of sales volumes and by the pass-through of increases or decreases in the Company's gas purchase costs through its purchased gas adjustment clauses. Additionally, revenues are affected by increases or decreases in gross receipts taxes (revenue-related taxes) which are levied on sales revenue as collected from customers and remitted to the various taxing authorities. The increase in both operating revenues and gas purchase costs between periods was primarily due to an 11% increase in gas sales volume to 15,265 MMcf in 2001 from 13,731 MMcf in 2000 and by a 27% increase in the average cost of gas from $4.56 per Mcf in 2000 to $5.81 per Mcf in 2001. Changes in the average cost of gas resulted from seasonal impacts on demands for natural gas and the ensuing competitive pricing within the industry. The New England Operations generated a net increase of $37,122,000 in operating revenues, $18,214,000 in gas purchase and other energy costs and 2,754 MMcf of the increase in gas sales volume. Operating margin (operating revenues less gas purchase and other energy costs and revenue-related taxes) increased $20,094,000 for the three-month period ended September 30, 2001 compared with the same period in 2000. Net operating margin increased principally as a result of the acquisition of the New England Operations which contributed a net increase of $18,162,000 for the quarter ended September 30, 2001. The remaining increase is primarily due to the timing of a $10,973,000 annual revenue increase granted to Missouri Gas Energy effective August 6, 2001 and the $17,900,000 annual revenue increase granted to PG Energy effective on January 1, 2001. Operating expenses, which include operating, maintenance and general expenses, depreciation and amortization, and taxes other than on income and revenues, were $83,290,000 for the three-month period ended September 30, 2001, an increase of $25,447,000, compared with $57,843,000 in 2000. Operating expenses increased primarily as a result of the acquisition of the New England Operations which generated a net increase of $25,148,000. This was partially offset by the elimination of goodwill amortization resulting from the Company's adoption of Goodwill and Other Intangible Assets effective July 1, 2001. In accordance with this Standard, the Company has ceased the amortization of goodwill, which generated $2,735,000 of expense during the quarter ending September 30, 2000, and currently accounts for goodwill on an impairment-only approach. Additionally, in connection with the Company's Cash Flow Improvement Plan announced in July 2001, the Company began the divestiture of certain non-core subsidiaries and assets. As a result of prices of comparable businesses for various non-core properties, a goodwill impairment loss of $3,358,000 was recognized in depreciation and amortization on the consolidated statement of operations for the quarter ended September 30, 2001. See Goodwill in the Notes to the Consolidated Financial Statements included herein. Business reorganization and restructuring initiatives were commenced in August 2001 as part of a previously announced Cash Flow Improvement Plan designed to increase annualized pre-tax cash flow from operations by at least $50 million by the end of fiscal year 2002. Actions taken included (i) the offering of voluntary Early Retirement Programs ("ERPs") in certain of its operating divisions and (ii) a limited reduction in force ("RIF") within its corporate offices. ERPs, providing for increased benefits for those electing retirement, were offered to approximately 400 eligible employees across the Company's operating divisions, with approximately 60% of such eligible employees accepting. The RIF was limited solely to certain corporate employees in the Company's Austin and Kansas City offices with forty-eight employees being offered severance packages. As a result of actions associated with the business reorganization and restructuring, the Company expects an annual cost savings in a range of $30 million to $35 million. In connection with the business reorganization and restructuring, the Company recorded a one-time charge of $32,706,000 during the quarter ended September 30, 2001. The charge included $26.5 million of voluntary ERP's, RIF within the corporate offices and employee separation benefits, and $6.2 million connected with various business realignment and restructuring initiatives. The Company expects that most of the restructuring actions will be completed by the end of fiscal 2002. See Business Restructuring Charges in the Notes to the Consolidated Financial Statements included herein. Interest expense was $27,159,000 for the three-month period ended September 30, 2001, compared to $16,306,000 in 2000. Interest expense increased primarily due to a $485,000,000 bank note (the Term Note) entered into by the - -------------------------------------------------------------------------------- 22 SOUTHERN UNION COMPANY AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Company on August 28, 2000 for the acquisition of the New England Operations. The Company entered into the Term Note to (i) fund the cash consideration paid to stockholders of Fall River Gas, ProvEnergy and Valley Resources, (ii) refinance and repay long- and short-term debt assumed in the New England Operations, and (iii) acquisition costs of the New England Operations. The Company also assumed $113,321,000 in long-term debt of the New England Operations which was not refinanced or extinguished with the Term Note. See Debt and Capital Lease in the Notes to the Consolidated Financial Statements included herein. Other income for the three-month period ended September 30, 2001 was $23,596,000 compared to other expense of $5,513,000 in 2000. Other income for the three-month period ended September 30, 2001, includes gains of $17,166,000 generated through the settlement of several interest rate swaps, a gain of $4,653,000 realized through the sale of marketing contracts held by PG Energy Service, Inc. and $1,905,000 in interest and dividend income. This was partially offset by $1,606,000 of legal costs associated with ongoing litigation associated with the unsuccessful acquisition of Southwest Gas Corporation (Southwest). Other expense for the three-month period ended September 30, 2000 primarily consists of $3,195,000 of non-cash trading losses and $2,041,000 of costs associated with the aforementioned unsuccessful acquisition and related litigation. The effective federal and state income tax rate is 35% and 46% for the three months ended September 30, 2001 and 2000, respectively. The decline in the effective tax rate is due to the Company's recent adoption of Goodwill and Other Intangible Assets, previously discussed, which eliminates the amortization of goodwill, in which the majority was non-tax deductible. The Company adopted the Statement of Financial Accounting Standards Board (FASB) Accounting for Derivative Instruments and Hedging Activities on July 1, 2000. In accordance with the transition provisions of the Statement, the Company recorded a net-of-tax cumulative-effect-type gain of $602,000 in earnings to recognize the fair value of the derivative instruments that do not qualify for hedge accounting treatment under the Statement. The Company also recorded a net-of-tax cumulative effect-type gain of $826,000 in accumulated other comprehensive income to recognize at fair value all derivative instruments designated as cash flow hedging instruments. Twelve Months Ended September 30, 2001 and 2000 The Company recorded net earnings available for common stock of $40,856,000 for the twelve-month period ended September 30, 2001 compared with net earnings of $1,971,000 in 2000. Earnings per diluted share were $.74 in 2001 compared with earnings per diluted share of $.04 in 2000. Operating revenues were $1,962,314,000 for the twelve-month period ended September 30, 2001, compared with operating revenues of $891,387,000 in 2000. Gas purchase and other energy costs for the twelve-month period ended September 30, 2001 were $1,383,203,000, compared with $542,955,000 in 2000. Both operating revenues and gas purchase costs were primarily impacted by a 47% increase in gas sales volume from 121,483 MMcf in 2000 to 178,188 MMcf in 2001 and by an 85% increase in the average cost of gas from $3.82 per Mcf in 2000 to $7.07 per Mcf in 2001 due to increases in average spot market gas prices. The New England Operations and the Pennsylvania Operations generated a net increase of $463,727,000 and $105,108,000, respectively, in operating revenues, $287,439,000 and $95,182,000, respectively, in gas purchase and other energy costs and 34,765 MMcf and 3,762 MMcf, respectively, of the increase in gas sales volume. The remaining increases in operating revenue, gas purchase and other energy costs, and gas sales volume resulted principally from the colder weather in the Texas and Missouri Service territories in 2001 as compared to 2000. Missouri Gas Energy service territories experienced weather which was 107% of a 30-year measure for the twelve- month period ended September 30, 2001 compared with 79% in 2000. Weather for Southern Union Gas service territories for the twelve-month period ended September 30, 2001 was 112% of a 30-year measure compared with - -------------------------------------------------------------------------------- 23 SOUTHERN UNION COMPANY AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 71% in 2000. About half of the customers served by Southern Union Gas are weather normalized. Weather in the PG Energy service territories was 104% of a 30-year measure for the twelve-month period ended September 30, 2001 compared with 95% of a 30-year measure for the eleven-month period ended September 30 ,2000. Weather in the New England Division service territories was 102% of a 30-year measure for the twelve-month period ended September 30, 2001. Operating expenses, excluding business restructuring charges which was previously discussed, were $381,845,000 for the twelve-month period ended September 30, 2001, compared with operating expenses of $227,103,000 in 2000. Increases of $124,419,000 and $3,222,000 were the result of the acquisitions of the New England Operations and the Pennsylvania Operations, respectively. An increase in bad debt expense in the Texas and Missouri service territories of $18,150,000 resulted from an increase in delinquent customer receivables as a result of higher gas prices and colder weather. Also impacting operating expenses for the twelve-month period ended September 30, 2001 were increases in employee payroll and benefit costs and a goodwill impairment loss of $3,358,000, previously discussed. Interest expense was $114,372,000 for the twelve-month period ended September 30, 2001 compared to $59,434,000 in 2000. Interest expense increased primarily due to the Term Note entered into by the Company for the acquisition of the New England Operations, previously discussed, and the issuance of $300,000,000 of 8.25% Senior Notes on November 3, 1999 (8.25% Senior Notes) for the acquisition of the Pennsylvania Operations. The Company issued 8.25% Senior Notes to fund the acquisition of Pennsylvania Enterprises, Inc. and to extinguish $136,000,000 in existing debt of the Pennsylvania Operations. The Company also assumed long-term debt of the New England Operations, previously discussed, and $45,000,000 in long-term debt of the Pennsylvania Operations which was not refinanced or extinguished with the Term Note or the 8.25% Senior Notes. See Debt and Capital Lease in the Notes to the Consolidated Financial Statements included herein. Other income for the twelve-month period ended September 30, 2001 was $105,928,000 compared to other expense of $14,064,000 in 2000. Other income for the twelve-month period ended September 30, 2001 includes realized gains on the sale of a portion of Southern Union's holdings in Capstone Turbine Corporation of $74,582,000, gains of $17,166,000 generated through the settlement of several interest rate swaps, previously discussed, a $13,532,000 gain on the sale of non-core real estate, a gain of $4,653,000 realized through the sale of marketing contracts held by PG Energy Service, Inc., also previously discussed, and $8,831,000 in interest and dividend income. These items were partially offset by $12,420,000 of legal costs associated with ongoing litigation associated with the unsuccessful acquisition of Southwest and $2,489,000 of non-cash trading losses. Other expense for the twelve-month period ended September 30, 2000 included: $12,404,000 of legal costs associated with the aforementioned unsuccessful acquisition and related litigation and $5,431,000 of non-cash trading losses which was partially offset by net rental income of Lavaca Realty of $1,985,000. The Company's consolidated federal and state effective income tax rate was 47% and 42% for the twelve-month period ended September 30, 2001 and 2000, respectively. The increase in the effective federal and state income tax rate is a result of non-tax deductible amortization of goodwill associated with the purchase of the New England Operations and Pennsylvania Operations. - -------------------------------------------------------------------------------- 24 SOUTHERN UNION COMPANY AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following table sets forth certain information regarding the Company's gas utility operations for the three- and twelve- month periods ended September 30, 2001 and 2000: Three Months Ended Twelve Months Ended September 30, September 30, 2001 2000 2001 2000 ---------- ---------- ---------- ---------- Average number of gas sales customers served: Residential............ 1,313,526 1,052,786 1,328,356 1,044,172 Commercial............. 125,102 103,348 128,480 103,775 Industrial and irrigation........... 4,237 773 4,310 751 Public authorities and other............ 3,156 3,151 3,162 3,147 Pipeline and marketing. 350 370 352 263 ---------- ---------- ---------- ---------- Total average customers served. 1,446,371 1,160,428 1,464,660 1,152,108 ========== ========== ========== ========== Gas sales in millions of cubic feet (MMcf) Residential............ 6,960 5,518 109,468 70,271 Commercial............. 3,675 3,279 44.324 29,886 Industrial and irrigation........... 1,009 527 5,440 1,797 Public authorities and other............ 245 290 3,201 2,625 Pipeline and marketing. 2,982 3,388 15,925 17,083 ---------- ---------- ---------- ---------- Gas sales billed... 14,871 13,002 178,358 121,662 Net change in unbilled gas sales............ 394 729 (170) (179) ---------- ---------- ---------- ---------- Total gas sales.... 15,265 13,731 178,188 121,483 ========== ========== ========== ========== Gas sales revenues (thousands of dollars): Residential............ $ 96,788 $ 61,576 $1,155,138 $ 494,133 Commercial............. 36,186 24,780 429,417 183,246 Industrial and irrigation........... 7,713 3,264 46,198 10,493 Public authorities and other............ 1,599 1,846 26,346 12,904 Pipeline and marketing. 11,482 13,713 76,649 52,151 ---------- ---------- ---------- ---------- Gas revenues billed........... 153,768 105,179 1,733,748 752,927 Net change in unbilled gas sales revenues... 3,374 5,363 4,807 3,664 ---------- ---------- ---------- ---------- Total gas sales revenues......... $ 157,142 $ 110,542 $1,738,555 $ 756,591 ========== ========== ========== ========== Gas sales margin (thousands of dollars)... $ 61,103 $ 43,029 $ 409,311 $ 257,593 ========== ========== ========== ========== Gas sales revenue per thousand cubic feet (Mcf) billed: Residential............ $ 13.91 $ 11.16 $ 10.55 $ 7.03 Commercial............. 9.85 7.56 9.69 6.13 Industrial and irrigation........... 7.64 6.19 8.49 5.84 Public authorities and other............ 6.53 6.37 8.23 4.92 Pipeline and marketing. 3.85 4.05 4.81 3.05 Weather: Degree days: Southern Union Gas service territories.. 2 5 2,377 1,516 Missouri Gas Energy service territories.. 67 66 5,542 4,150 PG Energy service territories.......... 195 260 6,556 5,547 New England service territories.......... 118 -- 6,009 -- Percent of normal based on 30-year measure: Southern Union Gas service terri- tories............. 36.7% 100.0% 112.0% 70.6% Missouri Gas Energy service terri- tories............. 108.1% 111.9% 106.5% 79.1% PG Energy service territories........ 162.5% 216.7% 104.2% 94.5% New England service territories........ 120.1% -- 102.1% -- Gas transported in millions of cubic feet (MMcf)................... 19,483 16,910 93,429 81,332 Gas transportation reve- nues (thousands of dollars)................. $ 7,012 $ 7,414 $ 45,209 $ 36,294 - ---------------------- The above information does not include the Company's 43% equity ownership in a natural gas distribution company serving 25,000 customers in Piedras Negras, Mexico. Information for Fall River Gas and ProvEnergy, acquired September 28, 2000, and Valley Resources, acquired September 20, 2000, is included since October 1, 2000. The 30-year measure is used above for consistent external reporting purposes. Measures of normal weather used by the Company's regulatory authorities to set rates vary by jurisdiction. Periods used to measure normal weather for regulatory purposes range from 10 years to 30 years. - -------------------------------------------------------------------------------- 25 SOUTHERN UNION COMPANY AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FINANCIAL CONDITION The Company's gas utility operations are seasonal in nature with a significant percentage of the annual revenues and earnings occurring in the traditional heating-load months. This seasonality results in a high level of cash flow needs immediately preceding the peak winter heating season months, resulting from the required payments to natural gas suppliers in advance of the receipt of cash payments from the Company's customers. The Company has historically used internally generated funds and its credit facilities to provide funding for its seasonal working capital, continuing construction and maintenance programs and operational requirements. On May 29, 2001, the Company restated and amended its short-term and long-term credit facilities (together referred to as "Revolving Credit Facilities"). The Company has available $150,000,000 under the short-term facility, which expires May 28, 2002, and $225,000,000 under the long-term facility, which expires on May 29, 2004. The Company has additional availability under uncommitted line of credit facilities with various banks. Borrowings under the Revolving Credit Facilities are available for Southern Union's working capital, letter of credit requirements and other general corporate purposes. A balance of $193,000,000 was outstanding under the facilities at September 30, 2001. On August 28, 2000 the Company entered into the Term Note to fund (i) the cash portion of the consideration to be paid to the Fall River Gas' stockholders; (ii) the all cash consideration to be paid to the ProvEnergy and Valley Resources stockholders, (iii) repayment of approximately $50,000,000 of long- and short-term debt assumed in the mergers, and (iv) all related acquisition costs. As of September 30, 2001, a balance of $485,000,000 was outstanding under this Term Note. The Term Note, which initially expired on August 27, 2001, has been extended through August 26, 2002 for a fee. No additional draws can be made on the Term Note. Concurrent with the closing of the Pennsylvania Enterprises, Inc. merger on November 4, 1999, the Company issued $300,000,000 of 8.25% Senior Notes due 2029 which were used to: (i) fund the cash portion of the consideration to be paid to the Pennsylvania Enterprises, Inc. shareholders; (ii) refinance and repay certain debt of Pennsylvania Enterprises, Inc., and (iii) repay outstanding borrowings under the Company's various credit facilities. These senior notes are senior unsecured obligations and will rank equally in right of payment with each other and with the Company's other unsecured and unsubordinated obligations, including the 7.60% Senior Notes due 2024. The principal sources of funds during the three-month period ended September 30, 2001 were $17,166,000 generated from the settlement of interest rate swaps, proceeds from the sale of various subsidiaries of $21,077,000 and $4,972,000 generated through the sale of commercial and industrial gas marketing contracts held by PG Energy Services, Inc. This provided funds of $24,390,000 for on-going property, plant and equipment additions; as well as seasonal working capital needs of the Company. The effective interest rate under the Company's current debt structure is 5.27% (including interest and the amortization of debt issuance costs and redemption premiums on refinanced debt). The Company retains its borrowing availability under its Revolving Credit Facilities, as discussed above. Borrowings under these credit facilities will continue to be used, as needed, to provide funding for the seasonal working capital needs of the Company. Internally-generated funds from operations will be used principally for the Company's ongoing construction and maintenance programs and operational needs and may also be used periodically to reduce outstanding debt. - -------------------------------------------------------------------------------- 26 SOUTHERN UNION COMPANY AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK There are no material changes in market risks faced by the Company from those reported in the Company's Annual Report on Form 10-K for the year ended June 30, 2001. The information contained in Item 3 updates, and should be read in conjunction with, information set forth in Part II, Item 7 in the Company's Annual Report on Form 10-K for the year ended June 30, 2001, in addition to the interim consolidated financial statements, accompanying notes, and Management's Discussion and Analysis of Financial Condition and Results of Operations presented in Items 1 and 2 of this Quarterly Report on Form 10-Q. ACCOUNTING PRONOUNCEMENTS In June 2001, the FASB issued Accounting for Asset Retirement Obligations, which addresses financial accounting and reporting for obligations and the related retirement costs associated with the retirement of tangible long-lived assets. Accounting for Asset Retirement Obligations is effective for all fiscal years beginning after June 15, 2002. The Statement's purpose is to develop consistent financial treatment of asset retirement obligations and the associated costs, improve disclosure regarding the impact of retirement obligations on future cash outflows, leverage and liquidity, and provide more information related to gross investment in long-lived assets. The Company is currently evaluating the effect this Statement will have on the earnings and financial condition of the Company. CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING INFORMATION This Management's Discussion and Analysis of Financial Condition and Results of Operations and other sections of this Form 10-Q may contain forward-looking statements that are based on current expectations, estimates and projections about the industry in which the Company operates, management's beliefs and assumptions made by management. Words such as "expects," "anticipates," "intends," "plans," "believes," "seeks," "estimates," variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions, which are difficult to predict and many of which are outside the Company's control. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in such forward-looking statements. The Company undertakes no obligation to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise. Readers are cautioned not to put undue reliance on such forward-looking statements. Stockholders may review the Company's reports filed in the future with the Securities and Exchange Commission for more current descriptions of developments that could cause actual results to differ materially from such forward-looking statements. Factors that could cause or contribute to actual results differing materially from such forward-looking statements include the following: cost of gas; gas sales volumes; weather conditions in the Company's service territories; the achievement of operating efficiencies and the purchases and implementation of new technologies for attaining such efficiencies; impact of relations with labor unions of bargaining-unit employees; the receipt of timely and adequate rate relief; the outcome of pending and future litigation; governmental regulations and proceedings affecting or involving the Company; unanticipated environmental liabilities; changes in business strategy; the risk that the businesses acquired and any other businesses or investments that Southern Union has acquired or may acquire may not be successfully integrated with the businesses of Southern Union; and the nature and impact of any extraordinary transactions such as any acquisition or divestiture of a business unit or any assets. These are representative of the factors that could affect the outcome of the forward-looking statements. In addition, such statements could be affected by general industry and market conditions, and general economic conditions, including interest rate fluctua tions, federal, state and local laws and regulations affecting the retail gas industry or the energy industry generally, and other factors. - -------------------------------------------------------------------------------- 27 SOUTHERN UNION COMPANY AND SUBSIDIARIES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. SOUTHERN UNION COMPANY ---------------------- (Registrant) Date November 14, 2001 By DAVID J. KVAPIL ------------------- ----------------- David J. Kvapil Executive Vice President and Chief Financial Officer - -------------------------------------------------------------------------------- -----END PRIVACY-ENHANCED MESSAGE-----