As filed with the Securities and Exchange Commission on June 27, 2005
Registration Statement No. _____________
================================================================================
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
--------------------
FORM S-1
REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933
--------------------
UNISOURCE ENERGY CORPORATION ARIZONA 86-0786732
(Exact name of registrant as (State or other jurisdiction of (I.R.S. Employer
specified in its charter) incorporation or organization) Identification No.)
ONE SOUTH CHURCH AVENUE, SUITE 1820, TUCSON, ARIZONA 85701,
(520) 571-4000 (Address, including zip code, and telephone number, including
area code, of registrants' principal executive offices)
KEVIN P. LARSON JOHN T. HOOD, Esq.
UniSource Energy Corporation Thelen Reid & Priest LLP
One South Church Avenue, Suite 1820 875 Third Avenue
Tucson, Arizona 85701 New York, New York 10022
(520) 571-4000 (212) 603-2000
(Names and addresses, including zip codes, and telephone numbers,
including area codes, of agents for service)
---------------------
APPROXIMATE DATE OF COMMENCEMENT OF PROPOSED SALE TO THE PUBLIC: From time
to time after the effective date of this registration statement as determined by
market conditions and other factors.
If the only securities being registered on this Form are being offered
pursuant to dividend or interest reinvestment plans, please check the following
box. [_]
If any of the securities being registered on this Form are to be offered on
a delayed or continuous basis pursuant to Rule 415 under the Securities Act of
1933, other than securities offered only in connection with dividend or interest
reinvestment plans, check the following box. [X]
If this Form is filed to register additional securities for an offering
pursuant to Rule 462(b) under the Securities Act, please check the following box
and list the Securities Act registration statement number of the earlier
effective registration statement for the same offering. [_]
If this Form is a post-effective amendment filed pursuant to Rule 462(c)
under the Securities Act, check the following box and list the Securities Act
registration statement number of the earlier effective registration statement
for the same offering. [_]
If delivery of the prospectus is expected to be made pursuant to Rule 434,
please check the following box. [_]
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CALCULATION OF REGISTRATION FEE
================================================================================================================================
PROPOSED MAXIMUM PROPOSED MAXIMUM
TITLE OF EACH CLASS OF SECURITIES AMOUNT TO BE OFFERING PRICE AGGREGATE AMOUNT OF
TO BE REGISTERED REGISTERED PER UNIT (B) OFFERING PRICE (C) REGISTRATION FEE
--------------------------------------------------------------------------------------------------------------------------------
4.50% Convertible Senior Notes due 2035 $150,000,000 (a) 100% $150,000,000 $17,655
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Common Stock, without par value 4,000,000 Shares (d) N/A N/A N/A (e)
--------------------------------------------------------------------------------------------------------------------------------
Right to Purchase Preferred Stock, Series 4,000,000 Rights (f) N/A N/A N/A
X, without par value
================================================================================================================================
(a) Represents the aggregate principal amount of the notes that were originally
issued by UniSource Energy Corporation in a private placement in March
2005.
(b) Equals the actual issue price of the aggregate principal amount of the
notes being registered. (c) Estimated for the sole purpose of determining
the registration fee based on Rule 457 under the Securities
Act of 1933.
(d) Reflects the number of shares of UniSource Energy Corporation common stock
issuable upon conversion of the notes being registered hereunder at the
initial rate of 26.6667 common shares per $1,000 principal amount of the
notes under certain conditions specified herein. Pursuant to Rule 416 under
the Securities Act of 1933, this registration statement also registers such
additional number of shares of UniSource Energy Corporation common stock as
may become deliverable upon conversion of the notes to prevent dilution
resulting from stock splits, stock dividends and similar transactions.
(e) No separate consideration will be received for the shares of UniSource
Energy Corporation common stock issuable upon conversion of the notes;
therefore, no additional registration fee is required pursuant to Rule
457(i) under the Securities Act of 1933.
(f) The rights to purchase UniSource Energy Corporation Preferred Stock, Series
X, without par value are attached to and will trade with the shares of
UniSource Energy Corporation's common stock. The value attributable to the
right to purchase the Preferred Stock, Series X, if any, is reflected in
the market price of the shares of UniSource Energy Corporation common
stock.
THE REGISTRANT HEREBY AMENDS THIS REGISTRATION STATEMENT ON SUCH DATE OR
DATES AS MAY BE NECESSARY TO DELAY ITS EFFECTIVE DATE UNTIL THE REGISTRANT SHALL
FILE A FURTHER AMENDMENT WHICH SPECIFICALLY STATES THAT THIS REGISTRATION
STATEMENT SHALL THEREAFTER BECOME EFFECTIVE IN ACCORDANCE WITH SECTION 8(A) OF
THE SECURITIES ACT OF 1933, AS AMENDED, OR UNTIL THIS REGISTRATION STATEMENT
SHALL BECOME EFFECTIVE ON SUCH DATE AS THE COMMISSION, ACTING PURSUANT TO SAID
SECTION 8(A), MAY DETERMINE.
================================================================================
SUBJECT TO COMPLETION, DATED JUNE 27, 2005
PROSPECTUS
$150,000,000
UNISOURCE ENERGY CORPORATION
4.50% CONVERTIBLE SENIOR NOTES DUE 2035 AND
SHARES OF COMMON STOCK (WITHOUT PAR VALUE) ISSUABLE UPON CONVERSION OF THE NOTES
We issued $150,000,000 of our 4.50% Convertible Senior Notes due 2035,
which we refer to in this prospectus as the "notes," in a private placement in
March 2005. Selling securityholders identified in this prospectus may use this
prospectus to resell from time to time the notes and the shares of our common
stock and preferred share purchase rights issuable upon conversion of the notes.
In this prospectus, we sometimes refer to the shares of our common stock
issuable or issued upon conversion of the notes as the "shares," and to the
notes and/or the shares and preferred share purchase rights, according to the
context, as the "securities."
We will pay interest on the notes semiannually each March 1 and
September 1, beginning on September 1, 2005. Beginning with the six-month period
commencing on March 1, 2015, we will pay contingent interest on the notes if the
average trading price of the notes is above a specified level, as described in
this prospectus.
The notes are convertible into shares of our common stock at any time
prior to the close of business on the business day immediately preceding the
maturity date at an initial conversion rate of 26.6667 shares of our common
stock per $1,000 principal amount of notes, which represents a conversion price
of approximately $37.50 per share of common stock, subject to adjustment as set
forth in this prospectus. In the event of a fundamental change (as described in
this prospectus), each holder may require us to repurchase for cash all or a
portion of such holder's notes at a price equal to 100% of the principal amount
of the notes, plus accrued and unpaid interest, including contingent interest
and additional interest, if any, up to but not including the date of repurchase.
In addition, in the event of a fundamental change that occurs before March 5,
2010, we will pay a make-whole premium on notes converted in connection
therewith, as described in this prospectus. Holders may require us to repurchase
for cash all or part of their notes on March 1, 2015, 2020, 2025 and 2030 at a
price equal to 100% of the principal amount of the notes, plus accrued and
unpaid interest, including contingent interest and additional interest, if any,
up to but not including the date of repurchase. The notes will mature on March
1, 2035.
On or after March 5, 2010, we may, at our option, redeem the notes, in
whole or in part, at a price equal to 100% of the principal amount of the notes,
plus accrued and unpaid interest, including contingent interest and additional
interest, if any, up to but not including the date of redemption. There is no
sinking fund for the notes.
The notes will be our senior unsecured obligations and will rank
equally with all of our other existing and future senior unsecured obligations
and will be junior to any of our future secured obligations to the extent of the
value of the collateral securing such obligations. Our obligations under the
notes will not be guaranteed and will be structurally subordinated in right of
payment to all obligations of our subsidiaries, including Tucson Electric Power
Company.
We have agreed, pursuant to a registration rights agreement, to file
the shelf registration statement, of which this prospectus forms a part, with
the Securities and Exchange Commission relating to resales of the notes and the
shares of our common stock issuable upon conversion of the notes. In the event
that we fail to comply with certain of our obligations under the registration
rights agreement, we will pay additional interest on the notes.
We and each holder of the notes have agreed in the indenture to treat
the notes as "contingent payment debt instruments" for United States federal
income tax purposes. You should read "Material U.S. Federal Income Tax
Considerations."
The notes are not listed on any securities exchange. Our common stock
is listed on the New York and Pacific stock exchanges under the symbol "UNS."
The closing price for our common stock on the New York Stock Exchange on June
21, 2005 was $29.70.
INVESTING IN THE NOTES INVOLVES RISKS. SEE "RISK FACTORS" BEGINNING ON
PAGE 6.
The notes are evidenced by global certificates deposited with a
custodian for and registered in the name of a nominee of The Depository Trust
Company, or DTC. Except as described in this prospectus, beneficial interests in
the global certificates will be shown on, and transfers thereon will be effected
only through, records maintained by DTC and its direct and indirect
participants.
The selling securityholders may sell the securities in negotiated
transactions or otherwise, at market prices prevailing at the time of sale, at
fixed or varying prices determined at the time of sale, or at negotiated prices.
The timing and amount of any sale are within the sole discretion of the selling
securityholders. In addition, the shares may be offered from time to time
through ordinary brokerage transactions on the New York or Pacific stock
exchanges. UniSource Energy Corporation will not receive any of the proceeds
from the sale of the securities by any of the selling securityholders. See PLAN
OF DISTRIBUTION.
NEITHER THE SECURITIES AND EXCHANGE COMMISSION NOR ANY STATE SECURITIES
COMMISSION HAS APPROVED OR DISAPPROVED OF THESE SECURITIES OR DETERMINED IF THIS
PROSPECTUS IS TRUTHFUL OR COMPLETE. ANY REPRESENTATION TO THE CONTRARY IS A
CRIMINAL OFFENSE.
, 2005
TABLE OF CONTENTS
NOTICE TO INVESTORS...........................................................ii
INFORMATION REGARDING UNISOURCE ENERGY CORPORATION............................ii
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS............................iii
PROSPECTUS SUMMARY.............................................................1
RATIO OF EARNINGS TO FIXED CHARGES.............................................5
RISK FACTORS...................................................................6
USE OF PROCEEDS...............................................................18
PRICE RANGE OF COMMON STOCK...................................................18
SELLING SECURITYHOLDERS.......................................................19
DESCRIPTION OF THE NOTES......................................................22
DESCRIPTION OF CAPITAL STOCK..................................................43
MATERIAL U.S. FEDERAL INCOME TAX CONSIDERATIONS...............................47
PLAN OF DISTRIBUTION..........................................................55
LEGAL MATTERS.................................................................58
EXPERTS.......................................................................58
Appendix A Annual Report on Form 10-K for Fiscal Year Ended December 31, 2004
Appendix B Quarterly Report on Form 10-Q for Period Ended March 31, 2005
Appendix C Proxy Statement for Annual Shareholders' Meeting held on May 6, 2005
NOTICE TO INVESTORS
THIS PROSPECTUS IS PART OF A REGISTRATION STATEMENT THAT WE FILED WITH
THE SECURITIES AND EXCHANGE COMMISSION, OR SEC, USING A "SHELF" REGISTRATION
PROCESS. UNDER THIS SHELF REGISTRATION PROCESS, THE SELLING SECURITYHOLDERS MAY
FROM TIME TO TIME OFFER SECURITIES COVERED BY THIS PROSPECTUS. EACH TIME A
SELLING SECURITYHOLDER OFFERS SECURITIES UNDER THIS PROSPECTUS, THE SELLING
SECURITYHOLDER WILL PROVIDE A COPY OF THIS PROSPECTUS AND, IF APPLICABLE, A COPY
OF A PROSPECTUS SUPPLEMENT. YOU SHOULD READ AND RELY ONLY ON THE INFORMATION
CONTAINED IN THIS PROSPECTUS AND, IF APPLICABLE, ANY PROSPECTUS SUPPLEMENT.
NEITHER WE NOR ANY SELLING SECURITYHOLDER HAS AUTHORIZED ANY OTHER PERSON TO
PROVIDE YOU WITH DIFFERENT OR ADDITIONAL INFORMATION. IF ANYONE PROVIDES YOU
WITH DIFFERENT OR ADDITIONAL INFORMATION, YOU SHOULD NOT RELY ON IT. THE SELLING
SECURITYHOLDERS ARE OFFERING TO SELL, AND ARE SEEKING OFFERS TO BUY, THE
SECURITIES ONLY IN JURISDICTIONS WHERE OFFERS AND SALES ARE PERMITTED. THIS
PROSPECTUS DOES NOT CONSTITUTE AN OFFER TO SELL, OR A SOLICITATION OF AN OFFER
TO BUY, ANY OF THE SECURITIES OFFERED BY THIS PROSPECTUS BY ANY PERSON IN ANY
JURISDICTION IN WHICH IT IS UNLAWFUL FOR SUCH PERSON TO MAKE SUCH AN OFFER OR
SOLICITATION. YOU SHOULD NOT ASSUME THAT THE INFORMATION CONTAINED IN THIS
PROSPECTUS IS ACCURATE AS OF ANY DATE OTHER THAN THE DATE ON THE FRONT COVER OF
THIS PROSPECTUS. OUR BUSINESS PROFILE, FINANCIAL CONDITION, RESULTS OF
OPERATIONS AND PROSPECTS MAY HAVE CHANGED SINCE THAT DATE.
INFORMATION REGARDING UNISOURCE ENERGY CORPORATION
We file annual, quarterly and other reports and other information with
the SEC. You can read and copy any information filed by us with the SEC at the
SEC's Public Reference Room at 450 Fifth Street, N.W., Washington, D.C. 20549.
You can obtain additional information about the Public Reference Room by calling
the SEC at 1-800-SEC-0330. In addition, the SEC maintains an internet site
(http://www.sec.gov) that contains reports, proxy and information statements,
and other information regarding issuers that file electronically with the SEC,
including us.
We have attached as part of this prospectus our Annual Report on Form
10-K for the year ended December 31, 2004 as Appendix A, our Quarterly Report on
Form 10-Q for the quarter ended March 31, 2005 as Appendix B and our Proxy
Statement for the 2005 Annual Shareholders' Meeting as Appendix C. These
appendices contain important information about our business profile, financial
condition and results of operations. We also maintain an internet site
(http://www.unisourceenergy.com). Information contained on our internet site
does not constitute part of this prospectus.
ii
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
This prospectus contains certain forward-looking statements, including,
without limitation, statements under the captions "Prospectus Summary," "Risk
Factors" and "Use of Proceeds" and any other statements located elsewhere in
this prospectus regarding our plans, objectives, goals, strategies, future
events or performance and underlying assumptions that are not statements of
historical facts. The words "anticipates," "estimates," "expects," "intends,"
"plans," "predicts," "projects" and similar expressions are intended to identify
forward-looking statements and information. You are cautioned not to place undue
reliance on these forward-looking statements, which speak only as of their
dates. These forward-looking statements are based on estimates and assumptions
by our management that, although we believe to be reasonable, are inherently
uncertain and subject to a number of risks and uncertainties.
The following list represents some, but not necessarily all, of the
factors that could cause actual results to differ from historical results or
those anticipated or predicted by these forward-looking statements:
o the ability of our subsidiaries to make distributions to us
in amounts sufficient to make required interest and
principal payments on the notes offered hereby or pay
dividends on any common stock issued upon conversion of the
notes;
o the effects of restructuring initiatives in the electric
industry and other energy-related industries;
o competition in retail and wholesale energy markets;
o changes in economic conditions, demographic patterns and
weather conditions in our retail service areas;
o supply and demand conditions in wholesale energy markets,
including volatility in market prices and illiquidity in
markets, which are affected by a variety of factors. These
factors include the availability of generating capacity in
the western U.S., including hydroelectric resources,
weather, natural gas prices, the extent of utility
restructuring in various states, transmission constraints,
environmental regulations and cost of compliance, Federal
Energy Regulatory Commission, or FERC, regulation of
wholesale energy markets, and economic conditions in the
western U.S.;
o the creditworthiness of the entities with which we and our
affiliates transact business or have transacted business;
o changes affecting our cost of providing electrical service
including changes in fuel costs, generating unit operating
performance, scheduled and unscheduled plant outages,
interest rates, tax laws, environmental laws, and the
general rate of inflation;
o changes in governmental policies and regulatory actions with
respect to financing and rate structures;
o changes affecting the cost of competing energy alternatives,
including changes in available generating technologies and
changes in the cost of natural gas;
o changes in accounting principles or the application of such
principles to our businesses;
o changes in the depreciable lives of our assets;
o market conditions and technological changes affecting our
unregulated businesses;
iii
o unanticipated changes in future liabilities relating to
employee benefit plans due to changes in market values of
retirement plan assets and health care costs;
o the outcome of any ongoing or future litigation;
o our substantial indebtedness; and
o our ability to obtain financing through debt and/or equity
issuances, which can be affected by various factors,
including interest rate fluctuations and capital market
conditions.
We caution you that the foregoing list of important factors is not
exclusive. In addition, in light of these risks and uncertainties, the matters
referred to in the forward-looking statements contained in this prospectus may
not in fact occur. We undertake no obligation to publicly update or revise any
forward-looking statement as a result of new information, future events or
otherwise, except as otherwise required by law.
iv
PROSPECTUS SUMMARY
This summary highlights information appearing elsewhere in this
prospectus, including in the appendices hereto. This summary is not complete and
does not contain all of the information that you should consider before
investing in the notes. You should read this entire prospectus carefully. This
prospectus contains forward-looking statements, which involve risks and
uncertainties. Our actual results could differ materially from those anticipated
in these forward-looking statements as a result of certain factors, including
those set forth in "Risk Factors" and elsewhere in this prospectus.
For purposes of this section, references to "we," "us," "our," and
"UniSource Energy" refer solely to UniSource Energy Corporation and not to its
subsidiaries unless the context clearly suggests otherwise.
OUR COMPANY
UniSource Energy is a utility holding company headquartered in Tucson,
Arizona. UniSource Energy has no significant operations of its own. Our
regulated subsidiaries are Tucson Electric Power Company, or TEP, and UniSource
Energy Services, or UES, which owns UNS Gas, Inc., or UNS Gas, and UNS Electric,
Inc., or UNS Electric. As of March 31, 2005, these companies provided energy to
approximately 600,000 customers across Arizona. Our subsidiaries Millennium
Energy Holdings, Inc., or Millennium, and UniSource Energy Development Company,
or UED, operate unregulated businesses. Our principal executive offices are
located at One South Church Avenue, Tucson, Arizona 85701. Our telephone number
is (520) 571-4000.
TUCSON ELECTRIC POWER COMPANY
TEP is a vertically-integrated, regulated utility that generates,
purchases, transports and distributes electricity to residential, commercial and
industrial customers. TEP's service territory consists of a 1,155 square mile
area and includes a population of approximately 931,000 in the Tucson
metropolitan area in Pima county, as well as parts of Cochise county. TEP
provides power to approximately 378,000 retail customers. TEP holds a franchise
to provide electric distribution service to customers in Tucson through 2026.
TEP is our largest business segment and contributed 76% of our operating
revenues for the year ended December 31, 2004 and comprised 84% of our assets as
of December 31, 2004.
UNS GAS
UNS Gas is a gas distribution company serving approximately 135,600
retail customers in Mohave, Yavapai, Coconino and Navajo counties in northern
Arizona, as well as Santa Cruz county in southeast Arizona.
UNS ELECTRIC
UNS Electric is an electric transmission and distribution company
serving approximately 86,500 retail customers in Mohave and Santa Cruz counties.
GLOBAL SOLAR AND OTHER UNREGULATED BUSINESSES
Millennium holds investments in various companies designed to develop
renewable energy and other emerging energy technologies, including Global Solar
Energy, Inc., or Global Solar, which develops and manufactures thin-film
photovoltaic cells and panels. The assets of Millennium comprised approximately
6% of UniSource Energy's consolidated assets as of December 31, 2004. UniSource
Energy intends to cease making capital contributions to Millennium.
THE FOREGOING INFORMATION ABOUT OUR BUSINESSES AND THE BUSINESSES OF OUR
PRINCIPAL SUBSIDIARIES IS ONLY A GENERAL SUMMARY AND IS NOT INTENDED TO BE
COMPREHENSIVE. FOR ADDITIONAL INFORMATION, YOU SHOULD REFER TO THE INFORMATION
DESCRIBED IN APPENDIX A, APPENDIX B AND APPENDIX C OF THIS PROSPECTUS.
FOR A DISCUSSION OF FACTORS THAT COULD CAUSE OUR ACTUAL RESULTS TO DIFFER
MATERIALLY FROM THOSE ANTICIPATED, SEE "RISK FACTORS."
1
THE OFFERING
Issuer.......................... UniSource Energy Corporation
Notes Offered................... $150,000,000 aggregate principal amount of
4.50% convertible senior notes due 2035.
Maturity Date................... March 1, 2035.
Interest Payment Dates.......... March 1 and September 1 of each year,
beginning September 1, 2005.
Interest........................ 4.50% per annum, payable semiannually, in
arrears. Interest will be computed on the
basis of a 360-day year comprised of twelve
30-day months.
Contingent Interest............. We will pay contingent interest to the
holders of notes during any six-month period
from March 1 to, and including, August 31
and from September 1 to, and including, the
last day of February, commencing with the
six-month period beginning March 1, 2015, if
the average note price (as described in this
prospectus) of a note for the five trading
days ending on the third trading day
immediately preceding the first day of the
relevant six-month period equals 120% or
more of the principal amount of such note.
The amount of contingent interest payable
per $1,000 principal amount of notes with
respect to any such period will be equal to
0.35% per annum of such average note price.
Guarantees...................... The notes will not be guaranteed.
Ranking......................... The notes will be our senior unsecured
obligations and will:
o rank equal in right of payment with all
of our other existing and future senior
unsecured obligations;
o rank junior in right of payment to any
of our future secured obligations to the
extent of the value of the collateral
securing such obligations; and
o be structurally subordinate in right of
payment to all existing and future
obligations of our subsidiaries.
In addition to the notes, UniSource Energy
has a secured credit facility comprised of a
$90 million term loan facility and a $15
million revolver. As of June 21, 2005, $80
million of the term loan was outstanding but
there were no borrowings outstanding under
the $15 million revolver. UniSource Energy
expects to borrow the remaining $10 million
available under the term loan facility by
June 30, 2005. As of March 31, 2005, the
notes were structurally subordinate to
approximately $1.9 billion of indebtedness
of our subsidiaries, $1.2 billion of which
was secured.
Right to Convert................ The notes are convertible into shares of our
common stock at any time prior to maturity,
redemption or repurchase, at an initial
conversion rate of 26.6667 shares of our
common stock per $1,000 principal amount of
notes (which represents a conversion price
of approximately $37.50 per share of common
stock) under the conditions and subject to
such adjustments as described under
"Description of the Notes--Conversion of
Notes."
2
Except as described in "Description of the
Notes--Conversion Rights," upon any
conversion, holders will not receive any
separate cash payment representing accrued
and unpaid interest, contingent or
additional interest, if any.
If holders convert their notes in connection
with a fundamental change, as described in
this prospectus, that occurs prior to March
5, 2010, they may also receive a make-whole
premium on the notes that they convert. See
"Description of the Notes--Conversion of
Notes--Payment Upon Conversion Upon a
Fundamental Change" and "Description of the
Notes--Determination of the Make-Whole
Premium."
Optional Redemption............. On or after March 5, 2010, we may, at our
option, redeem for cash, in whole or in
part, the notes that have not been
previously converted or purchased, at a
price equal to 100% of the principal amount
plus accrued and unpaid interest (including
contingent and additional interest), if any.
Put Rights...................... Holders may require us to repurchase for
cash all or part of their notes on March 1,
2015, 2020, 2025 and 2030 at a price equal
to 100% of the principal amount of the
notes, plus accrued and unpaid interest
(including contingent and additional
interest), if any, up to, but not including,
the date of repurchase.
Fundamental Change.............. If a fundamental change occurs, each holder
of the notes may require us to repurchase
for cash all or a portion of such holder's
notes at a price equal to 100% of their
principal amount, plus accrued and unpaid
interest (including contingent and
additional interest), if any, up to, but not
including, the date of repurchase.
Make-Whole Premium Upon a
Fundamental Change............ In the event of a fundamental change that
occurs prior to March 5, 2010, we may be
required to pay a make-whole premium on
notes converted in connection with the
fundamental change. The make-whole premium
will be payable in shares of our common
stock, or the consideration into which our
common stock has been converted or exchanged
in connection with such fundamental change,
on the repurchase date for the notes after
the fundamental change.
The amount of the make-whole premium, if
any, will be based on the stock price (as
described in this prospectus) and the
effective date of the fundamental change. A
description of how the make-whole premium
will be determined and a table showing the
make-whole premium that would apply at
various stock prices and fundamental change
effective dates is set forth under
"Description of the Notes--Determination of
the Make-Whole Premium."
Sinking Fund.................... None.
Use of Proceeds................. The selling securityholders will receive all
of the net proceeds from the sale of the
securities. We will not receive any of the
proceeds from the sale of the securities by
the selling securityholders.
3
Registration Rights............. We have filed a shelf registration state-
ment, of which this prospectus is a part, to
cover resales of the securities under the
Securities Act. We have agreed to use our
commercially reasonable efforts to keep the
shelf registration statement effective until
certain specified times. If we fail to
satisfy this obligation, we will be required
to pay additional interest to the holders of
the securities. See "Description of the
Notes--Registration Rights."
Trustee and Paying Agent........ The Bank of New York
DTC Eligibility................. The notes were issued in book-entry form and
are represented by permanent global
certificates deposited with, or on behalf
of, The Depository Trust Company, or DTC,
and registered in the name of a nominee of
DTC. Beneficial interests in any of the
notes will be shown on, and transfers will
be effected only through, records maintained
by DTC or its nominee, and any such interest
may not be exchanged for certificated
securities, except in limited circumstances.
See "Description of the Notes--Book-Entry,
Delivery and Form."
Listing and Trading............. The notes are currently eligible for trading
on the PORTAL system; however, the notes
sold by the selling shareholders under this
prospectus are not expected to remain
eligible for trading on the PORTAL system.
We have not applied, and do not intend to
apply, for listing of the notes on any
securities exchange or the inclusion of the
notes on any automated dealer quotation
system. Consequently, your ability to sell
the notes may be limited by the absence of
an active trading market, and if one
develops, it may not be liquid. Our common
stock is listed on the New York and Pacific
stock exchanges under the symbol "UNS."
Governing Law................... The indenture and the notes are governed by,
and construed in accordance with, the laws
of the State of New York.
Risk Factors.................... An investment in the securities involves
risks. Prospective investors should
carefully consider the information set forth
under "Risk Factors" beginning on page 6 of
this prospectus before deciding to invest in
the notes.
U.S. Federal Income Tax
Considerations............ Under the indenture governing the notes, we
agreed, and by acceptance of a beneficial
interest in a note each holder of a note was
deemed to have agreed, to treat the notes as
indebtedness for U.S. federal income tax
purposes that is subject to the Treasury
Regulations governing contingent payment
debt instruments. Pursuant to such
treatment, a holder may recognize taxable
income in each year that is significantly in
excess of interest payments (whether fixed
or contingent) actually received that year.
Additionally, a holder will generally be
required to recognize ordinary income on the
gain, if any, realized on a sale, exchange,
conversion or redemption of the notes.
Holders are urged to consult their own tax
advisors with respect to the U.S. federal,
state, local and foreign tax consequences of
purchasing, owning and disposing of the
notes and common stock issuable upon
conversion of the notes. See "Risk
Factors--You should consider the U.S.
federal income tax consequences of owning
the notes" and "Material U.S. Federal Income
Tax Considerations."
4
RATIO OF EARNINGS TO FIXED CHARGES
Our ratio of earnings to fixed charges is computed by dividing our
earnings by our fixed charges before income taxes. For the purposes of such
computations earnings are defined as pre-tax earnings from continuing operations
before minority interest, plus interest expense and amortization of debt
discount and expense related to indebtedness. Fixed charges are interest
expense, including amortization of debt discount and expense on indebtedness.
The following table shows our ratio of earnings to fixed charges for the periods
indicated:
----------------------------------------------------------------------------------------------------------------
Year ended Year ended Year ended Year ended Year ended Twelve Three months
December 31, December 31, December 31, December 31, December 31, months ended March
2000 2001 2002 2003 2004 ended 31, 2005*
March 31,
2005
----------------------------------------------------------------------------------------------------------------
1.38 1.77 1.36 1.37 1.43 1.37 0.88
----------------------------------------------------------------------------------------------------------------
* Our Ratio of Earnings to Fixed Charges for the three months ended March 31,
2005 is less than one-to-one coverage due to: the seasonal nature of TEP's
business; losses incurred by Global Solar.; and losses from other non-reportable
segments. In the first quarter of 2005, TEP incurred a net loss of $5 million,
Global Solar incurred a net loss of $2 million and other non-reportable segments
incurred a net loss of $2 million. The amount of the deficiency needed to attain
a one-to-one coverage would be $4 million.
5
RISK FACTORS
Your investment in the notes will involve substantial risks. You should
carefully consider the following factors in addition to the other information
set forth in this prospectus before you decide to purchase the notes offered
hereby. The risks and uncertainties described below are not the only ones facing
us. Additional risks and uncertainties that we do not presently know about or
that we currently believe are immaterial may also adversely impact our business
operations. If any of the following risks actually occur, our business,
financial condition, results of operations, cash flows and our ability to make
payments on the notes would likely suffer.
RISKS RELATING TO OUR INDEBTEDNESS AND THE NOTES
WE ARE A HOLDING COMPANY AND HAVE NO OPERATING INCOME OF OUR OWN. OUR ABILITY TO
MAKE PAYMENTS ON THE NOTES IS DEPENDENT ON RECEIVING DIVIDENDS AND OTHER
PAYMENTS FROM OUR SUBSIDIARIES. OUR SUBSIDIARIES DO NOT GUARANTEE OUR
OBLIGATIONS UNDER THE NOTES OFFERED HEREBY.
We have no operations of our own and derive all of our revenues and
cash flow from our subsidiaries. Our subsidiaries are separate and distinct
legal entities and have no obligation, contingent or otherwise, to pay amounts
due under the notes or to make any funds available to us to pay those amounts,
whether by dividend, distribution, loan or other payments. Our subsidiaries may
not be able to, or be permitted to, make distributions to us to enable us to
make payments in respect of our indebtedness, including the notes, due to
contractual restrictions. In addition, our regulated subsidiaries have made
certain commitments to the Arizona Corporation Commission ("ACC") and, in the
case of TEP and UNS Electric, are subject to constraints under the Federal Power
Act, that affect their ability to make distributions to us.
If we do not receive sufficient dividends and other payments from our
subsidiaries to service our debt, we may be required to refinance all or a
portion of our existing debt or to obtain additional financing. There can be no
assurance that any refinancing will be possible or that any additional financing
could be obtained on terms acceptable to us. Our inability to obtain additional
financing could have a material adverse effect on our financial position,
liquidity and results of operations.
WE HAVE A SUBSTANTIAL AMOUNT OF INDEBTEDNESS FOLLOWING THE ORIGINAL OFFERING OF
THE NOTES, WHICH MAY ADVERSELY AFFECT OUR ABILITY TO REMAIN IN COMPLIANCE WITH
DEBT COVENANTS AND MAKE PAYMENTS ON OUR INDEBTEDNESS, INCLUDING THE NOTES
OFFERED HEREBY.
Subsequent to the original offering of the notes, UniSource Energy
incurred additional indebtedness in the form of borrowings under a new UniSource
Energy credit agreement entered into in April 2005, to complete its strategy of
recapitalizing TEP. This indebtedness could make it more difficult for us to
satisfy our obligations with respect to the notes, and any failure to comply
with any financial and other restrictive covenants in our debt instruments could
result in an acceleration of such indebtedness and an event of default under the
indenture governing the notes.
We will be able to incur significant additional indebtedness in the
future. The indenture governing the notes does not contain restrictions on the
incurrence of additional indebtedness. If new debt is added to our current debt
levels, the related risks that we now face, including those described above,
would intensify.
THE NOTES WILL BE JUNIOR TO ANY SECURED DEBT THAT WE HAVE ISSUED OR MAY ISSUE IN
THE FUTURE AND WILL RANK EQUALLY WITH ALL OF OUR EXISTING AND ANY FUTURE SENIOR
INDEBTEDNESS THAT WE MAY INCUR.
The notes will be our senior unsecured indebtedness. Accordingly, the
notes will be junior to any secured debt, including our existing credit
agreement, that we have issued or may issue in the future to the extent of the
value of the collateral securing such obligations and will rank equally with all
of our existing and any future senior unsecured indebtedness that we may incur.
In the event of our bankruptcy, liquidation or reorganization or similar
proceeding, holders of any of our existing secured debt or future secured debt
we issue will have claims that are prior to your claims as holders of the notes
6
to the extent of the value of the assets securing such other secured debt. As a
result, there may not be sufficient assets remaining to pay amounts due on any
or all of the outstanding notes.
The indenture governing the notes does not prohibit or limit us or our
subsidiaries from incurring additional indebtedness, including additional senior
or secured indebtedness, and other liabilities, or from pledging assets to
secure such indebtedness and liabilities. The incurrence of additional
indebtedness and, in particular, the granting of a security interest to secure
the indebtedness, could adversely affect our ability to pay our obligations on
the notes.
THE NOTES OFFERED HEREBY ARE STRUCTURALLY SUBORDINATED TO ALL OF THE DEBT AND
LIABILITIES OF OUR SUBSIDIARIES.
The notes are structurally subordinated to all debt and liabilities of
our subsidiaries, including TEP. In the event of a bankruptcy, liquidation or
reorganization or similar proceeding relating to any of our subsidiaries, you
will participate with all other holders of our indebtedness in UniSource
Energy's claims to the assets remaining after such subsidiaries have paid all of
their debt and liabilities. In any of these cases, our subsidiaries may not have
sufficient funds to make payments to us, and you may receive no payments or
less, ratably, than the holders of debt and other liabilities of our
subsidiaries. Our subsidiaries will be able to incur significant indebtedness in
the future subject to compliance with applicable debt covenants and regulatory
requirements.
THE NOTES ARE NOT, AND MAY NOT BE, RATED.
We have no obligation, and do not intend, to have the notes rated. If
one or more rating agencies does rate the notes and assigns the notes a rating
lower than the rating expected by investors, or subsequently reduces any such
rating, the market price of the notes and our common stock would be harmed.
REGULATORY RESTRICTIONS LIMIT THE ABILITY OF OUR REGULATED SUBSIDIARIES TO MAKE
DISTRIBUTIONS TO US.
Regulatory restrictions limit the ability of our regulated subsidiaries
to make distributions to us. These restrictions include:
o a limitation on the payment of dividends to us unless
certain financial tests are satisfied; and
o a restriction on lending or transferring funds or issuing
securities without ACC approval.
The ACC has issued an order that prevents TEP from paying dividends
exceeding 75% of TEP's earnings unless its common equity equals at least 40% of
its total capitalization (which, as calculated by the ACC, includes common
equity, preferred equity and long-term debt, including current maturities of
such debt, and excludes capital lease obligations). As of March 31, 2005, the
ratio of TEP's common equity to total capitalization, determined on a pro forma
basis after giving effect to recent debt reductions and capital contributions
from UniSource Energy, and as calculated for ACC purposes, was approximately
40%.
The Federal Power Act also restricts electric utilities' ability to pay
dividends. Pursuant to the Federal Power Act, electric utilities cannot pay
dividends out of funds that are properly included in their capital account. TEP
has an accumulated deficit rather than positive retained earnings. Although the
terms of the Federal Power Act are unclear, we believe there is a reasonable
basis for TEP to pay dividends from current year earnings. However, the FERC
could attempt to stop TEP from paying further dividends or could seek to impose
additional restrictions on the payment of dividends.
Since TEP's ability to make distributions to us to is dependent on the
amount of its current net income, any condition or event which reduces its net
income would adversely affect its ability to make distributions to us.
Reductions in net income could result from decreased revenues or increased
expenses, including non-cash charges and charges resulting from changes in
accounting regulations or practices.
The ACC has also issued an order which prevents UNS Gas and UNS
Electric from paying dividends exceeding 75% of their earnings unless their
respective common equity is equal to at least 40% of their respective total
7
capitalization. As of March 31, 2005, the ratio of common equity to total
capitalization of UNS Gas and UNS Electric was approximately 41% and 43%,
respectively.
CONTRACTUAL RESTRICTIONS MAY RESULT IN US NOT HAVING ACCESS TO THE CASH FLOW OF
OUR SUBSIDIARIES THAT WILL BE NEEDED TO MAKE PAYMENTS ON THE NOTES OFFERED
HEREBY.
The terms of the credit facilities and other existing debt instruments
at our subsidiaries restrict their ability to pay dividends and otherwise
transfer assets to us. In addition, future agreements may not permit our
subsidiaries to provide us with sufficient dividends, distributions or loans to
fund scheduled interest and principal payments on the notes when due.
TEP cannot pay dividends to us unless it complies with the covenants in
its credit agreement, including covenants that require TEP to maintain a minimum
cash coverage ratios of 2.25 to 1.0 and a maximum total leverage ratio (all such
ratios being calculated as provided in the credit agreement). The following
table shows TEP's maximum leverage ratios under its credit agreement:
PERIOD MAXIMUM RATIO
------ -------------
Through and including December 31, 2005 4.75
From January 1, 2006 through and including 4.50
December 31, 2006
From January 1, 2007 through and including 4.25
December 31, 2007
After December 31, 2007 4.00
As of March 31, 2005, TEP's actual cash coverage ratio was 3.29 to 1.00 and its
actual leverage ratio was 4.29 to 1.00.
The ability of UNS Gas and UNS Electric to make dividend payments to us
is also restricted by the instruments governing their debt.
As of March 31, 2005, compliance with the covenants in the UNS Gas and
UNS Electric debt instruments would not have prevented dividends which would
otherwise have been permitted under the ACC limitations. It is unlikely,
however, that UNS Gas or UNS Electric will pay dividends in the next five years
due to their own expected cash requirements for capital expenditures.
OUR SUBSIDIARIES HAVE A SUBSTANTIAL AMOUNT OF INDEBTEDNESS WHICH COULD ADVERSELY
AFFECT THEIR BUSINESS AND RESULTS OF OPERATIONS.
Our ability to make payments on the notes is dependent on the earnings
and distributions of funds from our subsidiaries. The substantial indebtedness
of our subsidiaries could have important consequences for their businesses and
results of operations and subsequently on their ability to distribute amounts to
us. For example, it could:
o require our subsidiaries to dedicate a substantial portion
of their cash flow to pay principal and interest on their
debt, which could reduce the funds available for working
capital, capital expenditures, acquisitions and other
general corporate purposes;
o make our subsidiaries more vulnerable to restrictions
imposed by new government regulations as well as changes in
general economic, industry and competitive conditions; and
8
o limit the ability of our subsidiaries to borrow additional
amounts for working capital, capital expenditures,
acquisitions, debt service requirements, execution of their
business strategy or other purposes.
In addition, the interest expense of our subsidiaries could increase if
interest rates rise because certain of their debt instruments bear interest at
floating rates. A one percent increase (decrease) in average interest rates
under these agreements would result in a decrease (increase) in UniSource
Energy's annual pre-tax net income of approximately $4 million.
The substantial indebtedness of our subsidiaries could make it more
difficult for our subsidiaries to comply with the obligations of their debt
instruments, and any failure to comply with the obligations of any of their debt
instruments, including financial and other restrictive covenants, could result
in an event of default under the agreements governing UniSource Energy's
indebtedness.
If our subsidiaries do not have sufficient earnings to service their
debt or make distributions to us to make payments on the notes, we and our
subsidiaries may be required to refinance all or part of their existing debt,
borrow more money or sell securities, none of which can we guarantee we will be
able to do. Any borrowings, issuance of securities or pledge of assets to secure
the payment of debt by our regulated subsidiaries would be subject to ACC
approval. Any refinancing of our or our subsidiaries' debt could be at higher
interest rates and could require us or them to comply with more onerous
covenants, which could further restrict our business operations. In addition,
the terms of existing or future debt instruments may restrict us and our
subsidiaries from adopting some of these alternatives.
THE TERMS OF OUR AND OUR SUBSIDIARIES' EXISTING DEBT INSTRUMENTS AND FUTURE DEBT
INSTRUMENTS MAY RESTRICT OUR CURRENT AND FUTURE OPERATIONS, PARTICULARLY OUR
ABILITY TO RESPOND TO CHANGES IN OUR BUSINESS OR TO TAKE CERTAIN ACTIONS.
Our credit facility, the credit facility at TEP and other existing debt
instruments of our subsidiaries contain, and any future indebtedness would
likely contain, a number of restrictive covenants that impose significant
operating and financial restrictions on us, including restrictions on our
ability to engage in acts that may be in our best long-term interests. As
described above, the TEP credit facility includes financial covenants, including
requirements to:
o maintain certain minimum cash coverage ratios; and
o not exceed certain maximum total leverage ratios.
Our credit facility also contains similar financial covenants. The financial
covenants contained in both credit facilities will become more restrictive over
time.
The TEP credit facility also includes covenants restricting, among
other things, the ability of TEP to:
o incur additional debt;
o pay dividends, or make redemptions and repurchases, with
respect to capital stock;
o incur certain liens;
o make certain loans and investments; and
o engage in mergers, acquisitions, asset sales and
sale/leaseback transactions.
Our credit facility includes covenants restricting, among other things,
our and our subsidiaries' ability to:
o pay dividends, or make redemptions and repurchases, with
respect to capital stock;
9
o incur additional debt;
o incur certain liens;
o make certain loans and investments; and
o engage in mergers, acquisitions, asset sales and
sale/leaseback transactions.
The operating and financial restrictions and covenants in our and our
subsidiaries' existing debt agreements and any future financing agreements may
adversely affect our ability to finance future operations or capital needs or to
engage in other business activities. A breach of any of the restrictive
covenants in any of our or our subsidiaries' credit facilities could result in a
default under the indenture governing the notes offered hereby.
WE MAY NOT BE ABLE TO REPURCHASE NOTES UPON A FUNDAMENTAL CHANGE OR UPON THE
EXERCISE OF THE HOLDERS' OPTIONS TO REQUIRE REPURCHASE OF THE NOTES.
Upon the occurrence of certain fundamental change events and on
specified dates, you will have the right to require us to repurchase your notes
at a purchase price in cash equal to 100% of the principal amount of your notes
plus accrued and unpaid interest, if any. Any future credit agreement or other
agreements relating to indebtedness to which we become a party may contain
similar provisions. In the event we experience a fundamental change that results
in us having to repurchase the notes offered hereby or upon the exercise of the
holders' options to require repurchase of the notes, we may not have sufficient
financial resources to satisfy all of our obligations under the notes and our
other debt instruments. Our failure to make the fundamental change offer or to
pay the fundamental change purchase price when due or to make payments upon the
exercise of the holders' options to require repurchase of the notes would result
in a default under the indenture governing the notes. In addition, the
fundamental change feature of the notes does not cover all corporate
reorganizations, mergers or similar transactions and may not provide you with
protection in a highly leveraged transaction. See "Description of the
Notes--Repurchase of Notes at the Option of Holders--Repurchase of Notes at the
Option of Holders Upon a Fundamental Change" and "Description of the
Notes--Consolidation, Merger and Sale of Assets."
THERE IS NO ESTABLISHED TRADING MARKET FOR THE NOTES. YOUR ABILITY TO SELL THE
NOTES MAY BE LIMITED BY THE ABSENCE OF AN ACTIVE TRADING MARKET, AND IF ONE
DEVELOPS, IT MAY NOT BE LIQUID.
The notes are a new issue of securities for which there currently is no
established trading market. Consequently, the notes will be relatively illiquid,
and you may be unable to sell your notes. The notes are currently eligible for
trading in PORTAL but are not expected to remain so after they are sold pursuant
to the registration statement of which this prospectus forms a part. We do not
intend to apply for the notes to be listed on any securities exchange or to
arrange for quotation on any automated dealer quotation system. The initial
purchasers have advised us that they intend to make a market in the notes, but
they are not obligated to do so. The initial purchasers may discontinue any
market-making in the notes at any time, in their sole discretion. As a result,
any trading market for the notes may not be liquid. You may not be able to sell
your notes at a particular time or at favorable prices or at all.
The liquidity of any market for the notes and the future trading prices
of the notes will depend on many factors, including:
o our operating performance and financial condition;
o prevailing interest rates;
o our ability to get the shelf registration statement related
to resales of the notes and the underlying shares of common
stock declared effective by the SEC;
o the interest of securities dealers in making a market in the
notes; and
10
o the market for similar securities.
Historically, the market for non-investment grade debt has been subject
to disruptions that have caused substantial volatility in the prices of
securities similar to the notes offered hereby. The market for the notes, if
any, may be subject to similar disruptions. Any such disruptions may adversely
affect the value of your notes.
YOU SHOULD CONSIDER THE U.S. FEDERAL INCOME TAX CONSEQUENCES OF OWNING THE
NOTES.
Under the indenture governing the notes, we have agreed, and by
acceptance of a beneficial interest in a note each holder of a note will be
deemed to have agreed, to treat the notes as indebtedness for U.S. federal
income tax purposes that is subject to the Treasury Regulations governing
contingent payment debt instruments (which are referred to as the "contingent
payment debt regulations"). For U.S. federal income tax purposes, interest
income on the notes will accrue at the rate of 6.50% per year, compounded
semi-annually, which rate represents our determination of the yield at which we
could issue a comparable non-contingent, non-convertible, fixed-rate debt
instrument with terms and conditions otherwise similar to the notes. A United
States Holder (as that term is defined in "Material U.S. Federal Income Tax
Considerations") will be required to accrue interest income on a constant yield
to maturity basis at this rate (subject to certain adjustments), with the result
that a United States Holder generally will recognize taxable income
significantly in excess of interest payments received while the notes are
outstanding.
A United States Holder will also recognize gain or loss on the sale,
conversion, exchange, redemption or retirement of a note in an amount equal to
the difference between the amount realized on the sale, conversion, exchange,
redemption or retirement of a note, including the fair market value of our
common stock received, and the United States Holder's adjusted tax basis in the
note. Any gain recognized on the sale, conversion, exchange, redemption or
retirement of a note will be ordinary interest income and any loss will be
ordinary loss to the extent of the interest previously included in income, and
thereafter, capital loss.
The application of the contingent payment debt regulations to
instruments such as the notes is uncertain in several significant respects, and,
as a result, no assurance can be given that the Internal Revenue Service ("IRS")
or a court will agree with the treatment described herein. No ruling will be
obtained from the IRS concerning the application of the contingent payment debt
regulations to the notes. Any differing treatment could materially affect the
amount, timing and character of income, gain or loss in respect of an investment
in the notes. In particular, a holder might be required to accrue interest
income at a higher or lower rate, might not recognize income, gain or loss upon
conversion of the notes into shares of our common stock, might recognize capital
gain or loss upon a taxable disposition of the notes and might have an adjusted
tax basis in the notes or our common stock acquired upon conversion of a note
materially different than described herein.
Additionally, we are uncertain as to whether we are a U.S. real
property holding corporation for U.S. federal income tax purposes. If we are or
become a U.S. real property holding corporation, certain Non-United States
Holders (as that term is defined in "Material U.S. Federal Income Tax
Considerations") may be subject to U.S. federal income tax on any gain realized
on (a) the sale, conversion, exchange, redemption or retirement of the notes or
(b) the sale or other disposition of our common stock received upon conversion.
The material U.S. federal income tax consequences of the purchase,
ownership and disposition of the notes are summarized in this prospectus under
the heading "Material U.S. Federal Income Tax Considerations."
WE EXPECT THAT THE TRADING VALUE OF THE NOTES WILL BE SIGNIFICANTLY AFFECTED BY
THE PRICE OF OUR COMMON STOCK AND OTHER FACTORS.
The market price of the notes is expected to be significantly affected
by the market price of our common stock. This may result in greater volatility
in the trading value of the notes than would be expected for non-convertible
debt securities.
BEFORE CONVERSION, HOLDERS OF THE NOTES WILL NOT BE ENTITLED TO ANY STOCKHOLDER
RIGHTS WITH RESPECT TO OUR COMMON STOCK, BUT HOLDERS WILL BE SUBJECT TO ALL
CHANGES AFFECTING OUR COMMON STOCK.
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Holders of notes will not be entitled to any rights with respect to our
common stock (including, without limitation, voting rights and rights to receive
any dividends or other distributions on our common stock), but holders will be
subject to all changes affecting the common stock. A holder will only be
entitled to rights with respect to the common stock if and when we deliver
shares of common stock to the holder upon conversion of its notes. For example,
in the event that an amendment is proposed to our articles of incorporation or
bylaws requiring shareholder approval and the record date for determining the
shareholders of record entitled to vote on the amendment occurs prior to the
conversion date, the holders of the notes will not be entitled to vote on the
amendment, although they will nevertheless be subject to any changes in the
powers, preferences or special rights of our common stock.
WE MAY ISSUE ADDITIONAL SHARES OF COMMON STOCK AND THEREBY MATERIALLY AND
ADVERSELY AFFECT THE PRICE OF OUR COMMON STOCK.
We are not restricted from issuing additional common stock during the
remaining life of the notes and we have no obligation to consider the interests
of the holders of notes in connection with any such issuance. If we issue
additional shares of common stock, it may materially and adversely affect the
price of our common stock and, in turn, the price of the notes.
OUR SHAREHOLDER RIGHTS PLAN AND CERTAIN PROVISIONS OF ARIZONA LAW AND THE NOTES
OFFERED HEREBY COULD LIMIT ANOTHER PARTY'S ABILITY TO ACQUIRE US.
Our shareholder rights plan and the provisions of Arizona Law described
below under "Description of Capital Stock", individually or collectively, may
make it difficult for another company to acquire control of us, even if the
transaction would result in the shareholders receiving a premium for their
shares over current market prices. Certain provisions of the notes may also have
a similar effect.
RISKS RELATING TO OUR BUSINESS
OUR REGULATED SUBSIDIARIES ARE SUBJECT TO COMPREHENSIVE ENERGY REGULATION, AND
CHANGES IN OUR REGULATED SUBSIDIARIES' REGULATORY ENVIRONMENT AND RECENT EVENTS
IN THE ENERGY MARKETS THAT ARE BEYOND OUR CONTROL MAY SIGNIFICANTLY AFFECT OUR
BUSINESS AND OUR ACCESS TO CAPITAL MARKETS.
Our regulated subsidiaries are subject to comprehensive and changing
governmental regulation at both the state and federal levels. Steps taken and
being considered at the state and federal levels continue to change the
structure of the electric industry and utility regulation.
At the state level, the ACC has jurisdiction over TEP's, UNS Gas' and
UNS Electric's rates charged to retail customers, the issuance of securities,
disposition of assets and transactions with affiliated parties.
At the federal level, our regulated subsidiaries are subject to
regulation by the FERC under the Federal Power Act, among other things. The FERC
has jurisdiction over rates for electric transmission in interstate commerce and
rates for wholesale sales of electric power, among other things. The FERC
regulates the terms and prices of our regulated subsidiaries' transmission
services and sales of electricity at wholesale prices.
In July 2002, the FERC issued a Notice of Proposed Rulemaking on what
it called "standard market design," or "SMD," that called for "sweeping changes"
to the federal energy regulatory regime, including, among other things, a
proposed requirement that all transmission-owning utilities transfer control of
their transmission facilities to a regional transmission organization, or RTO.
TEP and other transmission owners in the southwest United States have made
various filings with the FERC regarding the formation of an RTO to be known as
WestConnect RTO, including an October 2001 petition for declaratory order as to
whether the WestConnect RTO proposal would satisfy FERC's criteria for an RTO.
An October 2002 FERC order, as clarified and reheard by a September 2003 FERC
order, found that, if modified in certain respects, the WestConnect RTO proposal
would generally satisfy FERC's RTO requirements. In an April 2003 white paper,
which used the term "wholesale market platform" in lieu of "SMD," FERC indicated
that it was considering a more flexible approach to the regulatory initiatives
contemplated by its July 2002 Notice of Proposed Rulemaking that would, among
other things, allow for greater regional variations between and among RTOs.
12
Participation in an RTO, like that which might be required or promoted
by FERC through a final order on SMD or other actions, would materially alter
the manner in which UniSource Energy's regulatory utilities own and operate
their transmission services. We cannot predict the precise nature or effect of
the FERC's SMD or RTO initiatives or whether WestConnect RTO will be approved as
proposed.
As a result of the energy crisis in California during 2000 and 2001,
the volatility of natural gas and electricity prices in North America, the
bankruptcy filings by Enron Corporation and Pacific Gas & Electric Company, and
investigations by governmental authorities into energy trading activities,
companies in the regulated and unregulated utility businesses have been under
increased scrutiny by state and federal regulators, the capital markets and the
rating agencies. We cannot predict or control what effect these types of events
or future actions of regulatory agencies may have on our business or our access
to capital markets.
DEREGULATION OR RESTRUCTURING OF THE ELECTRIC INDUSTRY MAY RESULT IN INCREASED
COMPETITION, WHICH COULD HAVE A SIGNIFICANT IMPACT ON OUR BUSINESS AND FINANCIAL
RESULTS.
In 1999, the ACC approved rules that provided a framework for the
introduction of retail electric competition in Arizona. Continued regulatory
developments and legal challenges to the rules, however, have raised uncertainty
about the status and pace of retail competition in Arizona. Currently, none of
TEP's retail customers are receiving energy from other providers. TEP cannot
predict when, and the extent to which, competitors will enter TEP's service
territory.
In January 2005, an Arizona Court of Appeals decision became final in
which the Court held invalid certain portions of the ACC rules on retail
competition and related market pricing. Based on this decision, we expect that
the ACC will address the competition rules in an administrative proceeding
during 2005. We cannot predict what changes, if any, the ACC will make to the
competition rules. Additionally, notwithstanding the presence of a 1999
settlement agreement addressing TEP rates and generation services, we cannot
predict whether the ACC will attempt to reinstate cost of service ratemaking for
all or a portion of TEP's generation services at a future point in time or
whether, in addressing its competition rules, the rate mechanisms established
under the 1999 settlement agreement will be modified prior to the expiration of
the 1999 settlement agreement in 2008.
As a result of changes in federal laws and regulatory policy,
competition in the wholesale market has greatly increased due to increased
participation by utilities, non-utility generators, independent power producers
and other wholesale power marketers and brokers. As of the end of 2004, electric
generating capacity in Arizona has grown to approximately 25,000 MW, an increase
of nearly 60% since 2001. A majority of this growth over the last three years is
the result of 16 new or upgraded gas-fired generating units with a combined
capacity of approximately 9,200 MW. Increased competition together with
increased supply could reduce the prices at which we sell electricity in the
wholesale market, which could reduce our wholesale sales and revenues. In
addition, the presence of fewer creditworthy counterparties, as well as legal,
political and regulatory uncertainties, has reduced market liquidity and trading
volume and therefore increased volatility in the wholesale energy markets.
RESTRICTIONS ON RATE INCREASES AT TEP, UNS GAS AND UNS ELECTRIC COULD NEGATIVELY
IMPACT OUR RESULTS OF OPERATIONS, CASH FLOWS AND NET INCOME.
TEP entered into a settlement agreement with certain customer groups in
1999 ("1999 Settlement Agreement"). TEP does not have a purchase power or fuel
adjustment rate mechanism. Under the terms of the settlement agreement, no rate
case filed by TEP through 2008 may result in a net rate increase. In the event
that power purchase, natural gas or coal costs, operation and maintenance or
other expenses increase, TEP could be adversely affected unless TEP were able to
seek recovery of such increased costs under emergency provisions of the 1999
settlement agreement. TEP may not be able to recover such costs.
On June 1, 2004, TEP filed general rate case information with the ACC.
TEP's filing does not propose any change in retail rates. Absent the restriction
on raising rates provided in the 1999 Settlement Agreement, we believe that the
data presented by TEP would justify an increase in retail rates of 16%. Despite
the indicated revenue deficiency, the ACC could conclude that TEP should
decrease rates. Such a decision could adversely affect TEP's results of
operations, cash flows and net income.
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Under the terms of the ACC order approving UniSource Energy's
acquisition of the Arizona gas and electric assets of Citizens Communications
Company ("Citizens") ("ACC Citizens Order"), UNS Gas and UNS Electric may not
file a general rate case until August 2006 and any resulting rate increase may
not become effective until August 1, 2007. UNS Gas has an automatic gas price
adjustment mechanism, known as the Purchased Gas Adjustor Factor, or PGA Factor,
through which increases or decreases in the cost of gas can be passed on to
customers. The PGA Factor is calculated on a 12-month rolling average of actual
gas costs and is subject to a cap on how much the factor can change in a
twelve-month period. When under- or over-recovery of gas costs reaches
approximately $4.5 million, UNS Gas may request a PGA surcharge or surcredit,
which is subject to a review by the ACC, with the goal of collecting or
refunding the amount deferred from or to customers. UNS Gas may therefore not be
able to recover increased fuel costs in a timely manner or at all. UNS Electric
has a purchase power and fuel rate adjustment clause which allows for adjustment
to the base rate for increased or lower power prices through a separate
surcharge or surcredit which must be approved by the ACC. Otherwise, UNS Gas and
UNS Electric must seek recovery of increased costs (such as maintenance or
capital expenditure costs) either through emergency provisions contained in the
ACC Citizens Order or through future general rate case proceedings. UNS Gas and
UNS Electric may not be able to recover such costs.
Prices for wholesale electricity and natural gas may fluctuate
substantially over relatively short periods of time and expose TEP, UNS Gas and,
to a lesser extent, UNS Electric to commodity price risks to the extent they
cannot be passed onto customers in a timely manner or at all. Wholesale
electricity prices in the western markets have been volatile in recent years. In
the event of shortfalls due to unforeseen increases in load demand or outages of
generation or transmission, TEP may need to purchase additional supplemental
power in the wholesale spot market at higher prices than are recovered through
existing rates.
Restrictions on rate increases at TEP, UNS Gas and UNS Electric also
expose them to other changes in costs related to interest rates, employee
benefits and other costs of doing business.
MATERIAL CHANGES TO TEP'S RETAIL RATES COULD OCCUR, WHICH COULD NEGATIVELY
IMPACT TEP'S RESULTS OF OPERATIONS, CASH FLOWS AND NET INCOME.
The 1999 Settlement Agreement provides that TEP's fixed competitive
transition charge ("fixed CTC") will expire when TEP's $450 million transition
recovery asset is fully amortized or on December 31, 2008, whichever is earlier.
Based on current projections of retail sales, the transition recovery asset is
expected to be fully amortized by mid-2008. Absent any other change to TEP's
retail rate structure, we estimate that the expiration of the fixed CTC (which
currently produces revenues of just under one cent per kWh sold) will result in
an average decrease in revenues from retail rates of approximately 12% relative
to revenues from current retail rates.
The 1999 Settlement Agreement also specifies that TEP's floating
competitive transition charge ("floating CTC") will expire on December 31, 2008.
This charge, which moves inversely to changes in TEP's market-based generation
services rate, presently appears as a credit on retail customer bills. Based on
current forward pricing in the wholesale energy markets, we anticipate that the
floating CTC will continue to appear as a credit on retail customer bills
through 2008. After the expiration of the floating CTC, TEP's rates for
generation services would be market-based. Absent any other change to TEP's
retail rate structure, expiration of the floating CTC would result in
market-based generation services rates which would, based on current forward
pricing in the wholesale energy markets, produce a significant retail rate
increase in January 2009 relative to current retail rates.
In an effort to resolve the uncertainty regarding the methodology that
will be applied to determine TEP's rates for generation service after the CTCs
expire, TEP filed a motion with the ACC on May 4, 2005 requesting that the ACC
issue an order declaring its position regarding the rate treatment that will be
afforded to TEP's generation assets after 2008.
In May 2005, a number of participants in TEP's rate proceedings,
including the staff of the ACC, filed responses to TEP's motion. Those responses
reflect differing interpretations of the 1999 Settlement Agreement. A number of
these responses dispute TEP's assertion that the existing rate structure
contemplates market-based rates for generation services after December 31, 2008.
14
On June 1, 2005, TEP filed a reply in support of its motion. The reply
states that the differences of opinion expressed in the various responses filed
underscore the need for the ACC to clarify how it will determine TEP's rates for
generation services after December 31, 2008. TEP's reply also states that,
although it would prefer that the ACC continue to authorize TEP to charge
market-based rates for generation services after December 31, 2008, it is
concerned that its customers will be subject to a significant increase in rates
in 2009. If the ACC intends to rescind TEP's authorization to charge
market-based rates for its generation services, that change will have immediate
consequences for the 1999 Settlement Agreement, the 2004 general rate case
information filing and future TEP rate cases. As a result, TEP suggested in its
reply modifications to the 1999 Settlement Agreement, including an extension of
existing rates beyond 2008. On June 10, 2005, an administrative law judge of the
ACC issued an order revising the schedule for TEP's 2004 rate review; however,
the order took no action on TEP's May 4, 2005 motion.
In the event that the ACC reinstates cost of service ratemaking for
TEP's generation services and does not allow other factors that have changed in
the intervening years to be considered, significant retail rate decreases could
occur. Any such rate decreases could negatively impact TEP's results of
operations, cash flows and net income.
THE EXPIRATION OF POWER SUPPLY AGREEMENTS AND OUR GROWING CUSTOMER BASE WILL
REQUIRE US TO FIND ALTERNATE SOURCES FOR A PORTION OF OUR ENERGY NEEDS.
Our electric utility subsidiaries are parties to power supply
agreements which expire between 2005 and 2008. UNS Electric has a full
requirements contract (approximately 390 MW in 2004) with Pinnacle West Capital
Corporation, or PWCC, which expires May 31, 2008. TEP has a 75 MW contract with
PPL Energy Plus, LLC expiring in December 2006, and a 50 MW contract with Panda
Gila River, LP through September 2005, as well as other short-term power
purchase agreements to meet 2005 summer load requirements.
The expiration of these contracts, with our growing customer base, will
require us to find other sources of energy to supply our customers. We may enter
into new purchase power contracts or we may invest in new generation facilities.
We may not be able, however, to identify additional investment opportunities or
make investments on favorable terms. In addition, we cannot assure you whether
we will be able to enter into purchase power contracts on favorable terms or at
all. If we are unable to do so, we may be required to purchase power on the spot
market which could expose us to volatile market prices. In addition, if capacity
problems develop in the western power markets, TEP and UNS Electric may find it
difficult or more expensive to replace the energy provided under their existing
agreements.
OUR UTILITY SUBSIDIARIES' REVENUES, RESULTS OF OPERATIONS AND CASH FLOWS ARE
SEASONAL AND ARE SUBJECT TO RISKS THAT ARE BEYOND THEIR CONTROL.
The seasonality of our utility subsidiaries' operations could impair
our ability to make payments on the notes when due. Our primary source of cash
to make required payments on the notes will be dividends from our utility
subsidiaries' net income. TEP typically earns the majority of its operating
revenue and net income in the third quarter because of high air conditioning
usage by its retail customers due to hot summer weather. Furthermore, TEP
typically reports limited net income in the first quarter because of relatively
mild winter weather in its retail service territory. UES' consolidated operating
results are expected to be less seasonal than TEP's due to sales of both
winter-peaking gas by UNS Gas and summer-peaking electricity by UNS Electric. In
addition, changes in the weather may adversely affect our operating revenues and
net income. When summer temperatures are lower than normal, or when winter
temperatures are higher than normal, we sell less power and consequently earn
less income. If cash on hand and borrowing availability are insufficient to
cover payments on the notes, this seasonality could adversely affect our ability
to make payments on the notes.
TEP MAY BE REQUIRED TO REDEEM SIGNIFICANT AMOUNTS OF ITS OUTSTANDING TAX-EXEMPT
BONDS.
TEP has financed a portion of its utility plant assets with
approximately $359 million of tax-exempt bonds for which the exemption from
income taxes requires that the financed facilities be used for the local
furnishing of electric energy. Various events, including, in certain
circumstances, the formation of an RTO or an independent system operator, asset
divestitures, changes in tax laws or changes in system operations, could cause
TEP to have to redeem or defease some or all of these bonds which could
adversely affect TEP's results of operations and cash flows. Any redemption or
15
defeasance of these bonds would likely require the issuance and sale of higher
cost taxable debt securities in the same or a greater principal amount.
OUR FACILITIES ARE SUBJECT TO OPERATIONAL RISKS.
TEP's generation assets use coal as the primary fuel for energy
generation. Although coal-fired generating stations are generally highly
reliable, operational failures and unscheduled outages occur from time to time.
Operational failures or unscheduled outages at our utility subsidiaries'
facilities, particularly during peak seasons, could result in unanticipated
power purchases which could adversely impact our utility subsidiaries' revenues,
operating and capital expenses and results of operations. Also, the cost of
repairing damage to our utility subsidiaries' facilities due to storms, natural
disasters, wars, terrorist acts and other catastrophic events in excess of
insurance coverage could adversely impact our utility subsidiaries' revenues,
operating and capital expenses, results of operations and net income.
TEP LEASES, RATHER THAN OWNS, A MATERIAL PORTION OF ITS GENERATION ASSETS.
TEP, under separate sale and leaseback arrangements, leases the
following generation facilities:
o coal handling facilities at Springerville Generating Station
("Springerville");
o a 50% undivided interest in the common facilities at
Springerville;
o Springerville Unit 1 and the remaining 50% undivided
interest in Springerville common facilities; and
o Sundt Unit 4 and related common facilities.
These leases expire at various times between 2011 and 2021. TEP may
renew the leases or purchase the leased assets at such times. These renewal and
purchase options are generally for fair market value as determined at that time.
The cost of renewing or purchasing the leased assets, or the cost of procuring
alternate sources of generation or purchased power, could adversely affect TEP's
results of operation, cash flows and net income.
In addition, in the event that the debt relating to the leases of the
50% undivided interest in the Springerville common facilities is not refinanced
by June 2006, such leases will terminate, and TEP will be required to repurchase
such interest in the common facilities for approximately $125 million. Any such
repurchase could adversely affect TEP's results of operations, cash flows and
net income.
THE HEDGING PROCEDURES OF TEP AND UNS GAS MAY NOT PROTECT THEIR SALES AND NET
INCOME FROM GAS PRICE VOLATILITY.
To lower their financial exposure to fluctuations in natural gas
prices, TEP and UNS Gas hedge a portion of their gas purchases with fixed price
contracts up to three years in advance. UNS Gas hedges with the goal of hedging
at least 45% and not more than 80% of its expected monthly gas consumption with
fixed prices prior to the delivery month. Both TEP and UNS Gas purchase their
remaining gas needs in the spot and short-term markets. To the extent they have
unhedged positions or their hedging procedures do not work as planned, their
business, results of operations, cash flows and net income could be adversely
affected.
WE ARE SUBJECT TO NUMEROUS ENVIRONMENTAL LAWS AND REGULATIONS WHICH MAY INCREASE
THE COST OF OPERATIONS OF OUR SUBSIDIARIES, IMPACT OUR BUSINESS PLANS OR EXPOSE
US TO ENVIRONMENTAL LIABILITIES.
We are subject to numerous federal, state and local environmental
regulations affecting our present and future operations, including regulations
regarding air emissions, water quality, wastewater discharges, solid waste, and
hazardous waste. Many of these regulations arise from TEP's use of coal as the
primary fuel for energy generation. These laws and regulations generally require
us to obtain and comply with a variety of environmental licenses, permits,
inspections and other approvals and can result in increased capital, operating
and other costs.
16
Existing environmental regulations may be revised or new regulations
may be adopted or become applicable to us. This may result in increased
compliance costs or additional operating restrictions, which may have an adverse
effect on our results of operations or financial condition.
OUR UTILITY SUBSIDIARIES MAY BE SUBJECT TO ENVIRONMENTALLY-RELATED LITIGATION
AND CONTRACTUAL OBLIGATIONS.
Our utility subsidiaries may be periodically subject to
environmentally-related litigation that may delay business initiatives, divert
management attention from other matters or impose liability on our utility
subsidiaries. There is pending litigation challenging existing permits and
seeking to impose more stringent emissions standards on the Springerville
Generating Station. These challenges could delay or prevent attainment of our
business goals. We cannot guarantee the outcome of these or any future lawsuits.
TEP is also contractually obligated to pay a portion of its
environmental reclamation costs at generating stations in which it has a
minority interest and possibly at the mines that supply these remote generating
stations. While TEP has recorded the portion of its costs that can be determined
at this time, the total costs for final reclamation at these sites are unknown
and could be substantial.
TEP MAY NOT RECEIVE REQUIRED REGULATORY APPROVALS TO CONSTRUCT A NEW
TUCSON-NOGALES TRANSMISSION LINE.
In January 2001, TEP and Citizens (now UES) entered into a project
development agreement for the joint construction of a 62-mile transmission line
from Tucson to Nogales, Arizona. This project was initiated by Citizens (now
UES) in response to an order by the ACC to improve reliability to its retail
customers in Nogales, Arizona. TEP is currently seeking approvals for the
project from the ACC, the Department of Energy ("DOE"), the U.S. Forest Service,
the U.S. Bureau of Land Management, and the International Boundary and Water
Commission.
There is disagreement among some of the agencies regarding the
preferred route for the transmission line. As a result, the ACC has ordered TEP
to re-open the state line siting process. The ACC has also ordered TEP to
investigate and engage in discussions with ACC staff and intervenors regarding
potential alternatives to the line.
The future costs of construction to Nogales, Arizona are expected to be
approximately $76 million. Through December 31, 2004, approximately $10 million
in land acquisition, engineering and environmental expenses have been
capitalized related to this project. If TEP does not receive the required
approvals, it may be required to expense $8 million of the costs that have been
capitalized related to the project, propose alternative methods to the ACC for
approving reliability and spend additional amounts to implement such
alternatives. The expenditures related to alternative methods for improving
reliability are expected to be less than $76 million.
WE EXPECT MILLENNIUM'S UNREGULATED BUSINESSES WILL CONTINUE TO REPORT LOSSES.
Although UniSource Energy intends to cease making capital contributions
to Millennium, we expect that Millennium will continue to report losses
affecting our results of operations. Millennium's current funding commitments to
its businesses total approximately $15 million. In addition, we may be required
to recognize impairment losses with respect to the Millennium businesses, which
had a net book value of approximately $106 million as of March 31, 2005.
17
USE OF PROCEEDS
The selling securityholders will receive all of the net proceeds from
the sales of the securities. We will not receive any of the proceeds from the
sales of the securities by the selling securityholders.
PRICE RANGE OF COMMON STOCK
Our common stock is listed on the New York and Pacific stock exchanges
under the ticker symbol "UNS." The following table sets forth, for the periods
indicated, the high and low sales prices per share of our common stock as
reported on the consolidated reporting system of the New York Stock Exchange.
--------------------------------------------------------------------------------
FISCAL QUARTER ENDED HIGH LOW
-------------------- ---- ---
--------------------------------------------------------------------------------
2003
--------------------------------------------------------------------------------
March 31................................ $ 18.10 $ 16.00
--------------------------------------------------------------------------------
June 30................................. 19.27 17.05
--------------------------------------------------------------------------------
September 30............................ 19.80 17.65
--------------------------------------------------------------------------------
December 31............................. 24.90 19.01
--------------------------------------------------------------------------------
2004
--------------------------------------------------------------------------------
March 31................................ $ 24.74 $ 24.11
--------------------------------------------------------------------------------
June 30................................. 24.93 24.15
--------------------------------------------------------------------------------
September 30............................ 24.94 24.20
--------------------------------------------------------------------------------
December 31............................. 24.88 22.90
--------------------------------------------------------------------------------
2005
--------------------------------------------------------------------------------
March 31................................ $ 34.80 $ 24.30
--------------------------------------------------------------------------------
Second quarter through June 21, 2005.... $ 31.98 $ 28.10
--------------------------------------------------------------------------------
On June 10, 2005, we paid a dividend of $0.19 per share to holders of
record as of May 18, 2005. On June 21, 2005, the closing price of our common
stock, as reported on the consolidated reporting system of the New York Stock
Exchange, was $29.70. On June 21, 2005, there were approximately 13,178 holders
of record.
The declaration of dividend payments on our common stock is at the sole
discretion of our board of directors and is subject to numerous factors,
including our directors' evaluation of our financial condition, earnings, cash
flows and dividend policy.
18
SELLING SECURITYHOLDERS
We originally issued the notes in a private placement in March 2005.
The initial purchasers of the notes have advised us that the notes were resold
in transactions exempt from the registration requirements of the Securities Act
to "qualified institutional buyers," as defined in Rule 144A of the Securities
Act. Selling securityholders may offer and sell the notes and/or shares of our
common stock issuable upon conversion of the notes pursuant to this prospectus.
References to the "selling securityholders" in this prospectus include those
persons listed in the table below, as well as the pledgees, donees, assignees,
transferees, successors and others who later hold any of the selling
securityholders' interests.
The selling securityholders are offering the securities under this
prospectus pursuant to existing registration rights conferred by the
registration rights agreement, as described under "Description of the
Notes--Registration Rights." The following table sets forth information, as of
June 21, 2005, with respect to the selling securityholders and the principal
amounts of the notes and number of shares beneficially owned by each of them
that may be offered under this prospectus. The information is based on
information provided by or on behalf of the selling securityholders. Unless set
forth below, to our knowledge, none of the selling securityholders has, or
within the past three years has had, any material relationship with us or any of
our predecessors or affiliates, or beneficially owns in excess of 1% of the
outstanding shares of our common stock. Since the date on which each selling
securityholder identified below provided this information, any of these selling
securityholders may have sold, transferred or otherwise disposed of all or a
portion of its securities in transactions exempt from the registration
requirements of the Securities Act or pursuant to this prospectus. Information
concerning the selling securityholders may change from time to time, and any
changed information will be set forth in supplements to this prospectus or in
post-effective amendments to the shelf registration statement, of which this
prospectus is part, to the extent required. In addition, the conversion rate,
and therefore the number of shares issuable upon conversion of the notes, is
subject to adjustment. Accordingly, the number of shares issuable upon
conversion of the notes may increase or decrease.
The selling securityholders may from time to time offer and sell
pursuant to this prospectus any or all of the securities. Because the selling
securityholders are not obligated to sell securities, we cannot estimate the
amount of the notes or how many shares of common stock that the selling
securityholders will hold upon consummation of any such sales.
Principal Amount of Number of Shares Percentage of
Notes Beneficially Percentage of of Common Stock Shares of
Owned That Notes That May Common Stock
Selling Securityholder May be Sold Outstanding be Sold (1) Outstanding (2)(3)
------------------------------------ ------------------- ------------- ---------------- ------------------
Acuity Master Fund, Ltd. $3,000,000 2.00% 80,000 *
Aloha Airlines Non Pilots Pension 10,000 0.01 267 *
Trust
Aloha Pilots Retirement Trust 5,000 0.00 133 *
Arkansas PERS 220,000 0.15 5,867 *
Associated Electric & Gas Insurance 200,000 0.13 5,333 *
Services Limited
Astrazeneca Holdings Pension 65,000 0.04 1,733 *
Attorneys Title Insurance Fund 20,000 0.01 533 *
Basso Holdings Ltd. 400,000 0.27 10,667 *
Basso Multi Strategy Holding Fund 1,600,000 1.07 42,667 *
Ltd.
BNP Paribas Equity Strategies, SNC 2,295,000 1.53 61,200 *
Boilermakers Blacksmith Pension 270,000 0.18 7,200 *
Trust
C&H Sugar Co. Inc. 15,000 0.01 400 *
CNH CA Master Account, L.P. 250,000 0.17 6,667 *
CooperNeff Convertible Strategies 842,000 0.56 22,453 *
(Cayman) Master Fund, LP
19
Principal Amount of Number of Shares Percentage of
Notes Beneficially Percentage of of Common Stock Shares of
Owned That Notes That May Common Stock
Selling Securityholder May be Sold Outstanding be Sold (1) Outstanding (2)(3)
------------------------------------ ------------------- ------------- ---------------- ------------------
Delaware Dividend Income Fund, a 250,000 0.17% 6,667 *
series of Delaware Group Equity
Funds V
Delaware PERS 125,000 0.08 3,333 *
Delta Airlines Master Trust 65,000 0.04 1,733 *
Duke Endowment 60,000 0.04 1,600 *
Fore Convertible Master Fund, Ltd. 4,000,000 2.67 106,667 *
Fore ERISA Fund, Ltd. 2,000,000 1.33 53,333 *
Fore Multi Strategy Master Fund, 3,000,000 2.00 80,000 *
Ltd.
Global Bermuda Limited Partnership 600,000 0.40 16,000 *
Grace Convertible Arbitrage Fund, 1,750,000 1.17 46,667 *
Ltd.
Guggenheim Portfolio Company VIII 2,000,000 1.33 53,333 *
(Cayman) Ltd.
Hallmark Convertible Securities Fund 15,000 0.01 400 *
Hawaiian Airlines Employees Pension 5,000 0.00 133 *
Plan IAM
Hawaiian Airlines Pension Plan for 5,000 0.00 133 *
Salaried Employees
Hawaiian Airlines Pilots Retirement 10,000 0.01 267 *
Plan
HighBridge International LLC 2,500,000 1.67 66,667 *
ICI American Holdings Trust 50,000 0.03 1,333 *
Institutional Benchmark Management 250,000 0.17 6,667 *
Fund c/o Quattro Fund
Jefferies & Co., Inc. 500,000 0.33 13,333 *
KBC Financial Products USA Inc. 585,000 0.39 15,600 *
Lakeshore International, Ltd. 2,400,000 1.60 64,000 *
LDG Limited 252,000 0.17 6,720 *
Lyxor/Convertible Arbitrage Fund 382,000 0.25 10,187 *
Limited
Lyxor/Quest Fund Ltd 700,000 0.47 18,667 *
Man Mac 1 Limited 2,000,000 1.33 53,333 *
MSS Convertible Arbitrage 1 c/o TQA 17,000 0.01 453 *
Nuveen Preferred & Convertible Fund 1,035,000 0.69 27,600 *
JQC
Nuveen Preferred & Convertible 755,000 0.50 20,133 *
Income Fund JPC
OCLC Online Computer Library Center 5,000 0.00 133 *
Inc.
Prudential Insurance Company of 15,000 0.01 400 *
America
20
Principal Amount of Number of Shares Percentage of
Notes Beneficially Percentage of of Common Stock Shares of
Owned That Notes That May Common Stock
Selling Securityholder May be Sold Outstanding be Sold (1) Outstanding (2)(3)
------------------------------------ ------------------- ------------- ---------------- ------------------
Quattro Fund Ltd. 4,500,000 3.00% 120,000 *
Quattro Multistrategy Masterfund LP 250,000 0.17 6,667 *
Quest Global Convertible Master 300,000 0.20 8,000 *
Fund Ltd
Sage Capital Management, LLC 3,500,000 2.33 93,333 *
Singlehedge US Convertible 336,000 0.22 8,960 *
Arbitrage Fund
Southern Farm Bureau Life Insurance 110,000 0.07 2,933 *
Sphinx Fund 309,000 0.21 8,240 *
State of Oregon Equity 610,000 0.41 16,267 *
Sturgeon Limited 395,000 0.26 10,553 *
Syngenta AG 30,000 0.02 800 *
TQA Master Fund, Ltd 1,978,000 1.32 52,747 *
TQA Master Plus Fund, Ltd 3,144,000 2.10 83,840 *
Vicis Capital Master Fund 5,000,000 3.33 133,333 *
Xavex - Convertible Arbitrage 7 c/o 186,000 0.12 4,960 *
TQA
Zurich Institutional Benchmarks 429,000 0.29 11,440 *
Master
Unnamed securityholders or any
future transferees, pledgees,
donees, assignees or successors
of or from any such unnamed
securityholder (4) 94,400,000 62.93 2,517,333 6.7636
-------------- ------ ------------ ----------
Total $ 150,000,000 100.0% 4,000,000 10.3355%(5)
============== ====== ============ ==========
----------------------
* Less than 1%
(1) Assumes conversion of all of the holder's notes at an initial conversion
rate of 26.6667 shares of our common stock per $1,000 principal amount of
the notes. However, this conversion rate will be subject to adjustment as
described under "Description of the Notes--Conversion of Notes--Conversion
Rate Adjustments." As a result, the number of shares of our common stock
issuable upon conversion of the notes may increase or decrease in the
future.
(2) Calculated on the basis of 34,701,669 shares of our common stock
outstanding as of June 21, 2005. In calculating this percentage, based on
Rule 13d-3(d)(1)(i) of the Exchange Act, we treated as outstanding that
number of shares of our common stock issuable upon conversion of all of the
particular holder's notes. However, we did not assume the conversion of any
other holder's notes.
(3) Assumes that all holders of notes, or any future transferees, pledgees,
donees, or successors of or from such holders of notes, do not beneficially
own any shares of our common stock other than the shares issuable upon
conversion of the notes at the initial conversion rate.
(4) Information about other selling securityholders will be provided in one or
more prospectus supplements or post-effective amendments to the
registration statement of which the prospectus is a part.
(5) Calculated by dividing the number of shares that the selling
securityholders may sell under this prospectus by the sum of the 34,701,669
shares of our common stock outstanding as of June 21, 2005 plus the
4,000,000 shares into which the $150,000,000 of notes are convertible.
21
DESCRIPTION OF THE NOTES
We issued the notes under an indenture between us and The Bank of New
York, as trustee. The notes and the shares issuable upon conversion of the notes
are covered by a registration rights agreement.
The following description is only a summary of the material provisions
of the notes, the indenture and the registration rights agreement. It does not
purport to be complete. We urge you to read these documents in their entirety
because they, and not this description, define the rights of holders of the
notes. You may request copies of these documents from us upon written request at
our address, which is listed in this prospectus under "Information Regarding
UniSource Energy Corporation."
For purposes of this section, references to "we," "us," "our" and
"UniSource Energy" refer solely to UniSource Energy Corporation and not to its
subsidiaries.
GENERAL
THE NOTES
The notes:
o are limited to $150,000,000 aggregate principal amount;
o mature on March 1, 2035, unless earlier converted by holders,
redeemed at our option or purchased by us at the option of
holders;
o bear interest at a rate of 4.50% per annum on the principal
amount, payable semi-annually, in arrears, on each March 1 and
September 1, beginning on September 1, 2005, to the holders of
record at the close of business on the preceding February 15 and
August 15, respectively;
o accrue contingent interest, which may be payable as set forth
below under "--Contingent Interest";
o will bear additional interest if we fail to comply with certain
obligations set forth below under "--Registration Rights";
o are convertible into shares of our common stock at an initial
conversion rate of 26.6667 shares of our common stock per $1,000
principal amount of notes (which represents a conversion price of
approximately $37.50 per share of common stock) under the
conditions and subject to such adjustments as are described below
under "--Conversion of Notes";
o are redeemable by us beginning on March 5, 2010, in whole or in
part, at a redemption price in cash equal to 100% of the
principal amount of the notes to be redeemed, plus accrued and
unpaid interest (including contingent interest and additional
interest), if any, under the conditions set forth below under
"--Optional Redemption;"
o are subject to repurchase by us for cash at the option of the
holders on March 1, 2015, 2020, 2025 and 2030, or upon the
occurrence of a "fundamental change" (as defined below under
"--Repurchase of Notes at the Option of Holders--Repurchase of
Notes at the Option of Holders Upon a Fundamental Change"), at a
repurchase price in cash equal to 100% of the principal amount of
the notes to be repurchased, plus accrued and unpaid interest
(including contingent interest and additional interest), if any,
to, but not including, the repurchase date as described below
under "--Repurchase of Notes at the Option of Holders--Optional
Put" and "--Repurchase of Notes at the Option of
Holders--Repurchase of Notes at the Option of Holders upon a
Fundamental Change;" and
o are represented by one or more registered securities in global
form as described below under "--Book-Entry, Delivery and Form."
The indenture does not contain any financial covenants and does not
restrict us or our subsidiaries from paying dividends, incurring additional
senior indebtedness or any other indebtedness or issuing or repurchasing
22
securities. The indenture contains no covenants or other provisions to afford
protection to holders of notes in the event of highly leveraged transactions or
a fundamental change of UniSource Energy, except to the extent described under
"--Repurchase of Notes at the Option of Holders--Repurchase of Notes at the
Option of Holders Upon a Fundamental Change" and "--Consolidation, Merger and
Sale of Assets."
The notes will be our general unsecured senior obligations, ranking
equally in right of payment with all of our existing and future unsecured senior
indebtedness, and senior in right of payment to any of our future indebtedness
that is expressly subordinated to the notes. The notes will be junior in right
of payment to all of our secured indebtedness to the extent of the value of the
collateral securing those obligations and structurally subordinated in right of
payment to all indebtedness and liabilities of our subsidiaries, including trade
credit.
No sinking fund is provided for the notes. The notes are issued only in
registered form, without coupons, in denominations of $1,000 principal amount
and multiples thereof.
We will maintain an office where the notes may be presented for
registration, transfer, exchange or conversion. This office will initially be an
office or agency of the trustee. Except under limited circumstances described
below, the notes will be issued only in fully registered book-entry form,
without coupons, and will be represented by one or more global securities. We
may pay interest by check mailed to each holder at its address as it appears in
the notes register; provided, however, that holders with notes in an aggregate
principal amount in excess of $2.0 million will be paid, at their written
election, by wire transfer of immediately available funds; provided further,
however, that payments to DTC will be made by wire transfer of immediately
available funds to the account of DTC or its nominee. There will be no service
charge for any registration of transfer or exchange of notes. We may, however,
require holders to pay a sum sufficient to cover any tax or other governmental
charge payable in connection with certain transfers or exchanges.
Holders may not sell or otherwise transfer the notes or the common
stock issuable upon conversion of the notes except in compliance with the
provisions set forth below under "--Registration Rights." Neither we nor the
registrar nor the trustee is required to exchange or register a transfer of:
o any notes for a period of 15 days before any mailing of a
redemption notice; or
o any notes that have been called for redemption or for which the
holder has delivered, and not validly withdrawn, a repurchase
notice or fundamental change repurchase notice, except, in the
case of a partial redemption or repurchase, that portion of the
notes not being redeemed or repurchased.
Each holder agreed in the indenture to treat the notes, for United
States federal income tax purposes, as "contingent payment debt instruments" and
to be bound by our application of the contingent payment debt regulations,
including our determination that the rate at which interest will be deemed to
accrue for U.S. federal income tax purposes will be 6.50%, compounded
semi-annually. The material U.S. federal income tax consequences of the
purchase, ownership and disposition of the notes are summarized in this
prospectus under the heading "Material U.S. Federal Income Tax Considerations."
STRUCTURAL SUBORDINATION
We are a holding company that derives substantially all of its income
from its operating subsidiaries. The notes will be structurally subordinated to
all indebtedness and other liabilities, including trade payables and debt, and
preferred stock incurred or issued by our subsidiaries. The indenture governing
the notes does not place any limit on the amount of liabilities, including trade
payables and debt, or preferred stock, that our subsidiaries may issue,
guarantee or otherwise incur.
INTEREST
The notes bear interest at a rate of 4.50% per annum on the principal
amount from March 1, 2005. We will pay interest semi-annually, in arrears, on
March 1 and September 1 of each year, beginning on September 1, 2005, subject to
limited exceptions if the notes are converted prior to the relevant interest
payment date. Interest will be paid to the holders of record at the close of
business on the February 15 and August 15, as the case may be, immediately
23
preceding the relevant interest payment date; provided, however, that interest
will be paid to a person other than the holder of record on the record date on
the maturity date or, in connection with a redemption at our option or
repurchase at the option of the holders, on the redemption date or repurchase
date, as the case may be, if it is after a record date but on or before the
corresponding interest payment date. In any such case, we will pay the accrued
and unpaid interest only to the person to whom we pay the principal amount.
Interest on the notes will accrue from the most recent date to which
interest has been paid or, if no interest has been paid, from the date of
original issuance. Interest will be computed on the basis of a 360-day year
comprised of twelve 30-day months. We will also pay contingent interest on the
notes in the circumstances described below under "--Contingent Interest."
Interest will cease to accrue on a note upon its maturity, conversion,
repurchase by us at the option of a holder or redemption.
CONTINGENT INTEREST
Subject to the accrual and record date provisions described above, we
will pay contingent interest to the holders of notes during any six-month period
from March 1 to, and including, August 31 and from September 1 to, and
including, the last day of February, commencing with the six-month period
beginning on March 1, 2015, if the average "note price" (as defined below) of a
note for the five trading days ending on the third trading day immediately
preceding the first day of the relevant six-month period equals 120% or more of
the principal amount of such note. The amount of contingent interest payable per
$1,000 principal amount of notes with respect to any such period will be equal
to 0.35% per annum of such average note price.
We will pay contingent interest, if any, in the same manner as we will
pay interest described above under "--Interest."
The "note price" on any date of determination means the average of the
secondary market bid quotations per $1,000 note obtained by the bid solicitation
agent for $10.0 million principal amount of notes at approximately 4:00 p.m.,
New York City time, on such determination date from three unaffiliated
securities dealers we select, provided that if:
o at least three such bids are not obtained by the bid solicitation
agent, or
o in our reasonable judgment, the bid quotations are not indicative
of the secondary market value of the notes,
then the note price will equal (a) the then-applicable conversion rate of the
notes multiplied by (b) the average of the "applicable stock price" (as defined
below) of our common stock for the last five trading days ending on such
determination date.
A "trading day" means a day during which trading in securities
generally occurs on the New York Stock Exchange or, if our common stock is not
listed on the New York Stock Exchange, on the principal other national or
regional securities exchange on which our common stock is then listed or, if our
common stock is not listed on a national or regional securities exchange, on the
National Association of Securities Dealers Automated Quotation system ("Nasdaq")
or, if our common stock is not quoted on Nasdaq, on the principal other market
on which such common stock is then traded.
The "applicable stock price," with respect to a trading day, is equal
to the volume-weighted average price per share of our common stock (or any
security into which our common stock has been converted in connection with a
fundamental change) on such trading day. The "volume-weighted average price,"
with respect to a trading day, means such price per share of our common stock as
displayed under the heading "Bloomberg VWAP" on Bloomberg (or any successor
service) page UNS -equity- AQR (or any successor page) in respect of the period
from 9:30 a.m. to 4:00 p.m., New York City time, on such trading day; or, if
such price is not available, the "applicable stock price" means the market value
per share of our common stock on such day as determined by a nationally
recognized independent investment banking firm retained for this purpose by us.
24
The bid solicitation agent will initially be the trustee. We may change
the bid solicitation agent, but it will not be one of our affiliates. The bid
solicitation agent will solicit bids from nationally recognized securities
dealers that are believed by us to be willing to bid for the notes.
Upon determination that holders of notes will be entitled to receive
contingent interest that may become payable during a relevant period, on or
prior to the start of such period, we will provide notice to all holders by
disseminating a press release setting forth the amount of contingent interest
per $1,000 principal amount of notes and publishing such release on our website.
CONVERSION OF NOTES
GENERAL
A holder may convert its notes, in whole or in part, into shares of our
common stock at any time prior to the close of business on the business day
immediately preceding the maturity date of the notes, unless we have redeemed or
purchased those notes. Holders may only convert notes with a principal amount of
$1,000 or an integral multiple of $1,000. The conversion rate with respect to a
note is initially 26.6667 shares of our common stock per $1,000 principal
amount. The conversion price of a note is equal to $1,000 divided by the then
applicable conversion rate at the time of determination. The conversion rate is
subject to adjustment as described below under "--Conversion Rate Adjustments."
Accordingly, an adjustment to the conversion rate will result in a corresponding
adjustment to the conversion price. The initial conversion price for the notes
is approximately $37.50 per share.
The shares issuable upon conversion will be delivered through the
conversion agent as soon as practicable following the conversion date. No
fractional shares will be issued upon conversion; in lieu thereof, a holder that
would otherwise be entitled to fractional shares of our common stock, will
receive a cash amount based on the applicable stock price of our common stock on
the trading day immediately before the conversion date.
If a holder exercises its right to require us to repurchase its notes
as described below under "--Repurchase of Notes at the Option of
Holders--Optional Put" and "--Repurchase of Notes at the Option of
Holders--Repurchase of Notes at the Option of Holders Upon a Fundamental
Change," such holder may convert its notes into shares of our common stock only
if it withdraws its applicable repurchase notice in accordance with the
indenture or if we default in the payment of the repurchase price.
PAYMENT UPON CONVERSION UPON A FUNDAMENTAL CHANGE
We must give notice of each fundamental change to all record holders
and to the trustee on a date (the "effective notice date") that is within 10
trading days after the effective date of the fundamental change. If a holder
converts its notes at any time beginning at the opening of business on the
effective notice date and ending at the close of business on the second trading
day immediately preceding the related fundamental change repurchase date
corresponding to such fundamental change, the holder will receive:
(1) common stock and cash for fractional shares, as
described above under "--Conversion of Notes--General";
plus
(2) the make-whole premium, if any, described under
"--Determination of the Make-Whole Premium", if the
fundamental change occurs before March 5, 2010.
CONVERSION RATE ADJUSTMENTS
The conversion rate will be adjusted:
(1) upon the issuance of shares of our common stock as a
dividend or distribution on our common stock;
(2) upon subdivisions, combinations or reclassifications of
our outstanding common stock;
25
(3) upon the issuance to all or substantially all holders
of our common stock of rights or warrants entitling
them for a period of not more than 60 days to subscribe
for or purchase our common stock, or securities
convertible into our common stock, at a price per share
or a conversion price per share less than the "current
market price" (as defined in the indenture) per share
on the record date for the issuance, provided that the
conversion rate for the notes will be readjusted to the
extent that the rights or warrants are not exercised
prior to their expiration;
(4) upon the distribution to all or substantially all
holders of our common stock of shares of our capital
stock, evidences of indebtedness or other non-cash
assets, or rights or warrants, excluding:
o dividends, distributions and rights or warrants
referred to in clause (1) or (3) above;
o a distribution referred to in clause (6) below; and
o distribution of rights pursuant to a shareholder rights
plan;
(5) upon the occurrence of any dividend or distribution
(other than in connection with a liquidation,
dissolution or winding up of UniSource Energy) to all
holders of our common stock during any quarterly fiscal
period, to the extent the aggregate amount of all such
dividends and distributions during such quarterly
fiscal period exceeds $0.19 per share of our common
stock (appropriately adjusted to reflect stock
dividends on, and subdivisions, combinations or
reclassifications of, our common stock) (such excess,
the "excess amount"), in which case, immediately prior
to the opening of business on the business day
immediately following the record date for the dividend
or distribution, the conversion rate shall be increased
so that it equals an amount equal to the conversion
rate in effect at the close of business on the record
date for the dividend or distribution multiplied by a
fraction:
(a) whose numerator is the average of the
volume-weighted average price per share of our
common stock for the five consecutive trading
days ending on the date immediately preceding the
"ex" date (as defined below) for such dividend or
distribution; and
(b) whose denominator is the same average
volume-weighted average price per share of our
common stock less the excess amount per share of
our common stock;
(6) upon the distribution of cash or other consideration by
us or any of our subsidiaries in respect of a tender
offer or exchange offer for our common stock, where
such cash and the value of any such other consideration
per share of our common stock validly tendered or
exchanged exceeds the "current market price" (as
defined in the indenture) per share of our common stock
on the last date (the "expiration date") on which
tenders or exchanges may be made pursuant to the tender
or exchange offer, in which case, immediately prior to
the opening of business on the business day after the
expiration date, the conversion rate shall be increased
so that it equals an amount equal to the conversion
rate in effect immediately before the close of business
on the expiration date multiplied by a fraction:
(a) whose numerator is the sum of:
(i) the aggregate amount of cash and the
aggregate value of any such other
consideration distributed in connection
with the tender or exchange offer; and
(ii) the product of (A) such "current market
price" per share of our common stock and
(B) the number of shares of our common
stock outstanding as of the last time (the
"expiration time") tenders or exchanges
could have been made pursuant to the
26
tender or exchange offer (excluding shares
validly tendered and not withdrawn in
connection with the tender or exchange
offer and any shares held in our
treasury); and
(b) whose denominator is the product of:
(i) such "current market price" per share of
our common stock; and
(ii) the number of shares of our common stock
outstanding as of the expiration time
(including shares validly tendered and not
withdrawn in connection with the offer,
but excluding any shares held in our
treasury).
For purposes hereof, the term "ex" date, when used with respect to any
dividend or distribution, means the first date on which the common stock trades,
regular way, on the relevant exchange or in the relevant market from which the
sale price was obtained without the right to receive such dividend or
distribution.
Notwithstanding the foregoing, in no event will the conversion rate
exceed 33.3333 shares per $1,000 principal amount of notes, as adjusted pursuant
to paragraphs (1), (2), (3), (4) and (6) above, as a result of an adjustment
pursuant to paragraph (5) above.
No adjustment to the conversion rate will be made if we provide that
the holders of notes will participate in the distribution without conversion, or
in certain other cases.
The conversion rate will not be adjusted:
o upon the issuance of any shares of our common stock pursuant to
any present or future plan providing for the reinvestment of
dividends or interest payable on UniSource Energy securities and
the investment of additional optional amounts in shares of our
common stock under any plan;
o upon the issuance of any shares of our common stock or options or
rights to purchase shares of our common stock pursuant to any
present or future employee, director or consultant benefit plan
or program of or assumed by UniSource Energy or any of its
subsidiaries;
o upon the issuance of any shares of our common stock pursuant to
any option, warrant, right or exercisable, exchangeable or
convertible security not described in the preceding bullet and
outstanding as of the date the notes were first issued; or
o for accrued and unpaid interest, including contingent interest or
additional interest, if any.
The holders will receive, upon conversion of the notes into our common
stock, in addition to the common stock, the rights under our rights plan or
under any future rights plan we may adopt, whether or not the rights have
separated from the common stock at the time of conversion unless, prior to
conversion, the rights have expired, terminated or been redeemed or exchanged.
See "Description of Common Stock."
In the event of:
- any reclassification of our common stock;
- a consolidation, merger or combination involving UniSource
Energy; or
- a sale or conveyance to another person of the property and
assets of UniSource Energy as an entirety or substantially as
an entirety,
in which holders of our outstanding common stock would be entitled to receive
stock, other securities, other property, assets or cash for their common stock,
holders of notes will generally thereafter be entitled to convert their notes
27
into the same type of consideration received by common stock holders immediately
following one of these types of events.
You may, in some circumstances, be deemed to have received a
distribution or dividend subject to U.S. federal income tax as a result of an
adjustment or the nonoccurrence of an adjustment to the conversion rate. See
"Material U.S. Federal Income Tax Considerations" below for a relevant
discussion.
Subject to applicable stock exchange rules and listing standards, we
are permitted to increase the conversion rate of the notes by any amount for a
period of at least 20 days if our Board of Directors determines that such
increase would be in our best interest. We are required to give at least 15
days' prior notice of any increase in the conversion rate. Subject to applicable
stock exchange rules and listing standards, we may also increase the conversion
rate to avoid or diminish income tax to holders of our common stock in
connection with a dividend or distribution of stock or similar event.
No adjustment in the conversion rate will be required unless it would
result in a change in the conversion rate of at least one percent. Any
adjustment not made will be taken into account in subsequent adjustments.
CONVERSION PROCEDURES
The right of conversion attaching to any note may be exercised (a) if
such note is represented by a global security, by book-entry transfer to the
conversion agent (which will initially be the trustee) through the facilities of
DTC, or (b) if such note is represented by a certificated security, by delivery
of such note at the specified office of the conversion agent, accompanied, in
either case, by a duly signed and completed conversion notice and appropriate
endorsements and transfer documents if required by the conversion agent. The
conversion date shall be the date on which the note and all of the items
required for conversion shall have been so delivered and the requirements for
conversion have been met.
No separate payment or adjustment will be made for accrued and unpaid
interest on a converted note or for dividends or distributions on any of our
common stock issued upon conversion of a note, except as provided in the
indenture. By delivering to the holder the number of shares issuable upon
conversion together with a cash payment in lieu of any fractional shares plus
any other consideration due upon conversion, we will satisfy our obligation with
respect to the conversion of the notes. That is, accrued interest (including
contingent interest and additional interest, if any) will be deemed to be paid
in full rather than canceled, extinguished or forfeited. We will not adjust the
conversion rate to account for any accrued interest, including contingent
interest and additional interest, if any.
If the holder converts after the close of business on a record date for
an interest payment but prior to the corresponding interest payment date, such
holder will receive on the interest payment date interest accrued on those
notes, notwithstanding the conversion of notes prior to the interest payment
date, assuming the holder was the holder of record at the close of business on
the corresponding record date. Each holder, however, agrees, by accepting a
note, that if the holder surrenders any notes for conversion during such period,
such holder must pay us at the time such holder surrenders its note for
conversion an amount equal to the interest that will be paid on the notes being
converted on the interest payment date. The preceding sentence does not apply,
however, if (1) we have specified a redemption date that is after a record date
for an interest payment but prior to the corresponding interest payment date or
(2) any overdue interest exists at the time of conversion with respect to the
notes being converted, but only to the extent of the amount of such overdue
interest. Accordingly, under the circumstances described in clause (1), a holder
of notes who chooses to convert those notes on a date that is after a record
date but prior to the corresponding interest payment date, will not be required
to pay us, at the time that holder surrenders those notes for conversion, the
amount of regularly scheduled interest it will receive on the interest payment
date.
Holders of notes are not required to pay any taxes or duties relating
to the issuance or delivery of our common stock upon exercise of conversion
rights, but they are required to pay any tax or duty which may be payable
relating to any transfer involved in the issuance or delivery of the common
stock in a name other than the name of the holder of the note. Certificates
representing shares of our common stock will be issued or delivered only after
all applicable taxes and duties, if any, payable by the holder have been paid.
28
The notes will be deemed to have been converted immediately prior to
the close of business on the conversion date. Delivery of shares will be
accomplished by delivery to the conversion agent of certificates for the
relevant number of shares, other than in the case of holders of notes in
book-entry form with DTC, which shares shall be delivered in accordance with DTC
customary practices. A holder will not be entitled to any rights as a holder of
our common stock, including, among other things, the right to vote and receive
dividends and notices of stockholder meetings, until the conversion is
effective.
A certificate for the number of full shares of common stock into which
the notes are converted (and cash in lieu of fractional shares) will be
delivered to such holder, assuming all of the other requirements have been
satisfied by such holder, as soon as practicable following the conversion date.
DETERMINATION OF THE MAKE-WHOLE PREMIUM
If a fundamental change occurs prior to March 5, 2010, we will pay a
make-whole premium upon certain conversions of the notes as described above
under "--Conversion of Notes-- Payment Upon Conversion Upon a Fundamental
Change". The make-whole premium will be equal to a percentage of the principal
amount of the notes converted. The make-whole premium will be in addition to,
and not in substitution for, any cash, securities or other assets otherwise due
to holders of notes upon conversion. The make-whole premium will be determined
by reference to the table below and is based on the date on which the
fundamental change becomes effective, referred to as the "effective date," and
the price, referred to as the "stock price," paid, or deemed to be paid, per
share of our common stock in the transaction constituting the fundamental
change, subject to adjustment as described below. If holders of our common stock
receive only cash in the fundamental change, the stock price shall be the cash
amount paid per share. In all other cases, the stock price will be the average
of the applicable stock prices of our common stock for the five consecutive
trading days beginning on the second trading day after the effective notice
date.
We will pay the make-whole premium solely in shares of our common stock
(other than cash in lieu of fractional shares) or in the same form of
consideration into which all or substantially all of the shares of our common
stock have been converted or exchanged in connection with the fundamental change
(other than cash paid in lieu of fractional interests in any security or
pursuant to dissenters' rights); provided, however, that we will pay cash in
lieu of fractional interests in any security or other property delivered in
connection with such fundamental change. The make-whole premium will be payable
on the fundamental change repurchase date after the fundamental change for notes
converted in connection with a fundamental change. If holders of our common
stock receive or have the right to receive more than one form of consideration
in connection with such fundamental change, then, for purposes of the foregoing,
the forms of consideration in which the make-whole premium will be paid will be
in proportion to the relative value, determined as described in the following
paragraph, of the different forms of consideration paid to our common
stockholders in connection with the fundamental change.
The value of our shares or other consideration for purposes of
determining the number of shares or other consideration to be issued in respect
of the make-whole premium will be calculated as follows:
(1) In the case of a fundamental change in which all or
substantially all of the shares of our common stock
have been, as of the effective date, converted into or
exchanged for the right to receive securities or other
assets or property, the consideration shall be valued
as follows:
(a) securities that are traded on a U.S. national
securities exchange or approved for quotation on
the Nasdaq or any similar system of automated
dissemination of quotations of securities prices,
will be valued at 98% of the average of the
applicable stock prices of such securities for
the five consecutive trading days beginning on
the second trading day after the effective notice
date,
(b) other securities, assets or property, other than
cash, that holders will have the right to receive
will be valued based on 98% of the average of the
fair market value of the securities, assets or
property, other than cash, as determined by two
independent nationally recognized investment
banks selected by the trustee, and
(c) 100% of any cash.
29
(2) In all other cases, the value of our shares will equal
98% of the average of the applicable stock prices of
our common stock for the five consecutive trading days
beginning on the second trading day after the effective
notice date.
Notwithstanding the foregoing, in no event shall the value of our
common stock be less than 50% of the applicable stock price of our common stock
used to determine the amount of the make-whole premium.
The stock prices set forth in the first column of the following table
will be adjusted as of any date on which the conversation rate of the notes is
adjusted. The adjusted stock prices will equal the stock prices applicable
immediately prior to the adjustment multiplied by a fraction, the numerator of
which is the conversion rate immediately prior to the adjustment to the
conversion rate and the denominator of which is the conversion rate as so
adjusted.
The following table sets forth the stock price, effective date and
make-whole premium (expressed as a percentage of principal amount) upon a
conversion in connection with a fundamental change:
MAKE-WHOLE PREMIUM
------------------
(% of Principal Amount)
-----------------------
------------------------------------------------------------------------------------------------------------
Effective Date
------------------------------------------------------------------------------------------------------------
Stock Price March 1, 2005 March 1, 2006 March 1, 2007 March 1, 2008 March 1, 2009 March 5, 2010
------------------------------------------------------------------------------------------------------------
$30.00 20.0% 19.3% 18.6% 17.6% 16.4% 15.9%
------------------------------------------------------------------------------------------------------------
$35.00 14.8 13.9 12.8 11.3 9.0 5.2
------------------------------------------------------------------------------------------------------------
$40.00 10.9 9.9 8.7 7.0 4.5 0.0
------------------------------------------------------------------------------------------------------------
$45.00 7.8 6.9 5.7 4.3 2.2 0.0
------------------------------------------------------------------------------------------------------------
$50.00 5.4 4.6 3.6 2.5 1.1 0.0
------------------------------------------------------------------------------------------------------------
$55.00 3.5 2.9 2.1 1.3 0.4 0.0
------------------------------------------------------------------------------------------------------------
$60.00 2.0 1.6 1.1 0.5 0.0 0.0
------------------------------------------------------------------------------------------------------------
$65.00 1.0 0.6 0.3 0.0 0.0 0.0
------------------------------------------------------------------------------------------------------------
$70.00 0.2 0.0 0.0 0.0 0.0 0.0
------------------------------------------------------------------------------------------------------------
$75.00 0.0 0.0 0.0 0.0 0.0 0.0
------------------------------------------------------------------------------------------------------------
The exact stock price and effective dates may not be set forth on the
table, in which case:
o if the stock price is between two stock prices on the table or
the effective date is between two effective dates on the table,
the make-whole premium will be determined by straight-line
interpolation between make-whole premium amounts set forth for
the higher and lower stock prices and the two effective dates, as
applicable, based on a 365-day year;
o if the stock price is in excess of $75.00 per share (subject to
adjustment in the same manner as the stock price), no make-whole
premium will be paid; and
o if the stock price is less than $30.00 per share (subject to
adjustment in the same manner as the stock price), no make-whole
premium will be paid.
Our obligation to pay the make-whole premium could be considered a
penalty, in which case the enforceability thereof would be subject to general
equitable principles of reasonableness of economic remedies.
OPTIONAL REDEMPTION
Prior to March 5, 2010, the notes will not be redeemable at our option.
On or after March 5, 2010, we may redeem the notes, in whole or in part, at a
purchase price in cash equal to 100% of the principal amount of those notes plus
30
accrued and unpaid interest (including contingent interest and additional
interest, if any) to, but not including, the redemption date.
We will give at least 15 days' but not more than 60 days' notice of
redemption by mail to holders of notes. Notes called for redemption are
convertible by the holder until the close of business on the business day
immediately preceding the redemption date.
If we do not redeem all of the notes, the trustee will select the notes
to be redeemed in principal amounts of $1,000 or multiples thereof by lot, on a
pro rata basis or by any other method that the trustee considers fair and
appropriate or in accordance with the applicable procedures of DTC to the extent
notes are held in book-entry form. If any notes are to be redeemed in part only,
we will issue a new note or notes with a principal amount equal to the
unredeemed principal portion thereof. If a portion of a holder's notes is
selected for partial redemption, and the holder converts a portion of its notes,
the converted portion will be deemed to be taken from the portion selected for
redemption.
If the paying agent holds cash sufficient to pay the redemption price
of the notes for which a redemption notice has been delivered on the redemption
date in accordance with the terms of the indenture, then, on and after the
redemption date, the notes will cease to be outstanding and interest (including
contingent interest and additional interest, if any) on such notes shall cease
to accrue, whether or not the notes are delivered to the paying agent.
Thereafter, all rights of the holder shall terminate, other than the right to
receive the redemption price upon delivery of the notes.
REPURCHASE OF NOTES AT THE OPTION OF HOLDERS
OPTIONAL PUT
On March 1, 2015, 2020, 2025 and 2030, a holder may require us to
repurchase for cash any outstanding notes for which the holder has properly
delivered and not withdrawn a written repurchase notice, subject to certain
additional conditions, at a purchase price in cash equal to 100% of the
principal amount of those notes plus accrued and unpaid interest (including
contingent interest and additional interest, if any) to, but not including, the
repurchase date. Holders may submit their repurchase notices to the paying agent
at any time from the opening of business on the date that is 20 business days
prior to the repurchase date until the close of business on the business day
immediately preceding the relevant repurchase date.
Unless we have elected to redeem all of the notes on or before the
repurchase date (to the extent permitted by the indenture), we are required to
give notice at least 20 business days prior to each repurchase date to all
holders at their addresses shown in the register of the registrar and to
beneficial owners as required by applicable law stating, among other things, the
procedures that holders must follow to require us to repurchase their notes as
described below. The repurchase notice given by each holder electing to require
us to repurchase notes shall be given so as to be received by the paying agent
no later than the close of business on the business day immediately preceding
the repurchase date and must state:
o if certificated notes are to be delivered, the certificate
numbers of the holder's notes to be delivered for repurchase;
o the portion of the principal amount of notes to be repurchased,
which must be $1,000 or a multiple thereof; and
o that the notes are to be repurchased by us pursuant to the
applicable provisions of the notes and the indenture.
A holder may withdraw any repurchase notice by delivering a written
notice of withdrawal to the paying agent prior to the close of business on the
business day immediately preceding the repurchase date. The notice of withdrawal
shall state:
o if certificated notes are to be withdrawn, the certificate
numbers of the notes being withdrawn;
31
o the principal amount of notes being withdrawn, which must be
$1,000 or an integral multiple thereof; and
o the principal amount, if any, of the notes that remain subject to
the repurchase notice.
If notes are not in certificated form, the foregoing notices must
comply with appropriate DTC procedures.
In connection with any repurchase, we will, to the extent applicable:
o comply with the provisions of Rule 13e-4, Rule 14e-1 and any
other tender offer rules under the Exchange Act that may then be
applicable; and
o otherwise comply with all federal and state securities laws in
connection with any offer by us to purchase the notes.
Our obligation to pay the purchase price for notes for which a
repurchase notice has been delivered and not validly withdrawn is conditioned
upon the holder delivering the notes, together with necessary endorsements, to
the paying agent at any time after delivery of the repurchase notice. We will
cause the repurchase price for the notes to be paid promptly following the later
of the repurchase date or the time of delivery of the notes, together with such
endorsements.
If the paying agent holds cash sufficient to pay the repurchase price
of the notes for which a repurchase notice has been delivered on the repurchase
date in accordance with the terms of the indenture, then, on and after the
repurchase date, the notes will cease to be outstanding and interest (including
contingent interest and additional interest, if any) on such notes will cease to
accrue, whether or not the notes are delivered to the paying agent. Thereafter,
all rights of the holder shall terminate, other than the right to receive the
repurchase price upon delivery of the notes.
REPURCHASE OF NOTES AT THE OPTION OF HOLDERS UPON A FUNDAMENTAL CHANGE
In the event of a fundamental change (as defined below) each holder
will have the right, at its option, subject to the terms and conditions of the
indenture, to require us to repurchase, in whole or in part, the holder's notes
in integral multiples of $1,000 principal amount, at a price in cash equal to
100% of the principal amount of such notes tendered, plus any accrued and unpaid
interest (including contingent interest and additional interest, if any) to, but
not including, the repurchase date. We will be required to repurchase the notes
on a date that is not less than 20 nor more than 45 business days after the date
we mail the notice referred to below.
Within 10 business days after a fundamental change has become
effective, we must mail to all holders of notes at their addresses shown in the
register of the registrar and to beneficial owners as required by applicable law
a notice regarding the fundamental change, which notice must state, among other
things:
- the events causing such fundamental change;
- the date of such fundamental change;
- the last date on which a holder may exercise the
repurchase right;
- the repurchase price;
- the repurchase date;
- the names and addresses of the paying and conversion
agents;
- the conversion rate, and any adjustments to the
conversion rate that will result from the fundamental
change;
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- that notes with respect to which a repurchase notice is
given by the holder may be converted, only if the
repurchase notice has been withdrawn in accordance with
the terms of the indenture; and
- the procedures that holders must follow to exercise
these rights.
To exercise this right, the holder must transmit to the paying agent a
written repurchase notice, and such repurchase notice must be received by the
paying agent no later than the close of business on the business day immediately
preceding the repurchase date. The repurchase notice must state:
- the certificate numbers of the notes to be delivered by
the holder, if applicable;
- the portion of the principal amount of notes to be
repurchased, which portion must be $1,000 or an
integral multiple of $1,000; and
- that such notes are being tendered for repurchase
pursuant to the fundamental change provisions of the
indenture.
A holder may withdraw any repurchase notice by delivering to the paying
agent a written notice of withdrawal prior to the close of business on the
business day immediately preceding the repurchase date. The notice of withdrawal
must state:
- the certificate numbers of the notes being withdrawn,
if applicable;
- the principal amount of notes being withdrawn, which
must be $1,000 or an integral multiple of $1,000; and
- the principal amount, if any, of the notes that remain
subject to the repurchase notice.
If the notes are not in certificated form, the foregoing notices from
holders must comply with the applicable DTC procedures.
We have agreed under the indenture to:
- comply with the provisions of Rule 13e-4, Rule 14e-1
and any other tender offer rules under the Exchange Act
that may then be applicable; and
- otherwise comply with all federal and state securities
laws in connection with any offer by us to repurchase
the notes upon a fundamental change.
Our obligation to pay the repurchase price for a note for which a
repurchase notice has been delivered and not validly withdrawn is conditioned
upon delivery of the note, together with necessary endorsements, to the paying
agent at any time after the delivery of such repurchase notice. We will cause
the repurchase price for such note to be paid promptly following the later of
the repurchase date or the time of delivery of such note.
If the paying agent holds money sufficient to pay the repurchase price
of a note for which a repurchase notice has been delivered on the repurchase
date in accordance with the terms of the indenture, then, on and after the
repurchase date, the notes will cease to be outstanding and interest (including
contingent interest and additional interest, if any) on such notes will cease to
accrue, whether or not the notes are delivered to the paying agent. Thereafter,
all rights of the holder shall terminate, other than the right to receive the
repurchase price upon delivery of the note.
A "fundamental change" will be deemed to have occurred upon the
occurrence of any of the following:
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(1) any "person" or "group" (other than us, our
subsidiaries or our respective employee benefit plans)
files a Schedule 13D or Schedule TO, or any successor
schedule, form or report under the Exchange Act,
disclosing, or we otherwise become aware, that such
person or group is or has become the "beneficial
owner," directly or indirectly, of shares of our voting
stock representing 50% or more of the total voting
power of all outstanding classes of our voting stock or
has the power, directly or indirectly, to elect a
majority of the members of our board of directors;
(2) we consolidate with, or merge with or into, another
person or we sell, assign, convey, transfer, lease or
otherwise dispose of all or substantially all of our
assets, or any person consolidates with, or merges with
or into, us, in any such event other than pursuant to a
transaction in which the persons that "beneficially
owned" directly or indirectly, the shares of our voting
stock immediately prior to such transaction
beneficially own, directly or indirectly, shares of
voting stock representing a majority of the total
voting power of all outstanding classes of voting stock
of the surviving or transferee person in substantially
the same proportion amongst themselves as such
ownership immediately prior to such transaction;
(3) a majority of the members of our board of directors are
not continuing directors (as defined below); or
(4) our common stock ceases to be listed on a national
securities exchange or quoted on The Nasdaq National
Market or another established automated
over-the-counter trading market in the United States.
However, a merger or consolidation will be deemed not to be a
fundamental change if at least 90% of the consideration (excluding cash payments
for fractional shares and cash payments pursuant to dissenters' appraisal
rights) in the merger or consolidation constituting the fundamental change
consists of common stock traded on a national securities exchange or quoted on
The Nasdaq National Market (or which will be so traded or quoted when issued or
exchanged in connection with such merger or consolidation) and as a result of
such transaction or transactions the notes become convertible solely into such
common stock.
For purposes of this fundamental change definition:
- "person" or "group" shall have the meanings given to them
for purposes of Sections 13(d) and 14(d) of the Exchange
Act or any successor provisions, and the term "group"
includes any group acting for the purpose of acquiring,
holding or disposing of securities within the meaning of
Rule 13d-5(b)(l) under the Exchange Act, or any successor
provision;
- a "beneficial owner" will be determined in accordance with
Rule 13d-3 under the Exchange Act, as in effect on the date
of the indenture;
- "beneficially own" and "beneficially owned" have meanings
correlative to that of beneficial owner;
- "board of directors" means the Board of Directors or other
governing body charged with the ultimate management of any
person;
- "continuing director" means, as of any date of
determination, any member of our board of directors who
was a member of such board of directors on the date of the
indenture; or was nominated for election or elected to
such board of directors with the approval of: (A) a
majority of the continuing directors who were members of
such board at the time of such nomination or election or
(B) a nominating committee, a majority of which committee
were continuing directors at the time of such nomination
or election;
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- "capital stock" means: (1) in the case of a corporation,
corporate stock; (2) in the case of an association or
business entity, any and all shares, interests,
participations, rights or other equivalents (however
designated) of corporate stock; (3) in the case of a
partnership or limited liability company, partnership
interests (whether general or limited) or membership
interests; or (4) any other interest or participation that
confers on a person the right to receive a share of the
profits and losses of, or distributions of assets of, the
issuing person;
- "voting stock" means any class or classes of capital stock
or other interests then outstanding and normally entitled
(without regard to the occurrence of any contingency) to
vote in the election of the board of directors, managers
or trustees.
The term "all or substantially all" as used in the definition of
fundamental change will likely be interpreted under applicable state law and
will be dependent upon particular facts and circumstances. There may be a degree
of uncertainty in interpreting this phrase. As a result, we cannot assure
holders how a court would interpret this phrase under applicable law if holders
elect to exercise their rights following the occurrence of a transaction which
such holders believe constitutes a transfer of "all or substantially all" of our
assets.
This fundamental change repurchase feature may make more difficult or
discourage a takeover of us and the removal of incumbent management. We are not,
however, aware of any specific effort to accumulate shares of our common stock
or to obtain control of us by means of a merger, tender offer, solicitation or
otherwise. In addition, the fundamental change repurchase feature is not part of
a plan by management to adopt a series of anti-takeover provisions. Instead, the
fundamental change repurchase feature is a result of negotiations between us and
the initial purchasers.
We could, in the future, enter into certain transactions, including
recapitalizations, that would not constitute a fundamental change but would
increase the amount of debt, including other senior indebtedness, outstanding or
otherwise adversely affect a holder. Neither we nor our subsidiaries are
prohibited from incurring debt, including other senior indebtedness, under the
indenture. The incurrence of significant amounts of additional debt could
adversely affect our ability to service our debt, including the notes.
Our ability to repurchase notes may be limited by restrictions on our
ability to obtain funds for such repurchase through dividends from our
subsidiaries and the terms of our then existing borrowing agreements. Our
failure to repurchase the notes when required would result in an event of
default with respect to the notes. We cannot assure holders that we would have
the financial resources, or would be able to arrange financing, to pay the
repurchase price for all the notes that might be delivered by holders of notes
seeking to exercise the repurchase right. See "Risk Factors--We may not be able
to repurchase notes upon a fundamental change or upon the exercise of the
holders' options to require repurchase of the notes."
EVENTS OF DEFAULT
Each of the following constitutes an event of default with respect to
the notes:
(1) a default in the payment when due of any principal of
any of the notes at maturity, upon redemption or
exercise of a repurchase right or otherwise;
(2) a default in the payment of any interest, contingent
interest, additional interest or any make-whole premium
when due under the notes, which default continues for
30 days;
(3) a default in our obligation to satisfy our conversion
obligation upon exercise of a holder's conversion
right;
(4) a default in our obligation to provide notice of the
occurrence of a fundamental change when required by the
indenture;
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(5) our failure to comply with any of our other agreements
in the notes or the indenture upon receipt of notice to
us of such default from the trustee or to us and the
trustee from holders of not less than 33% in aggregate
principal amount of the notes then outstanding, and our
failure to cure (or obtain a waiver of) such default
within 60 days after we receive such notice;
(6) UniSource Energy or TEP fails to make any payment of
principal in excess of $50,000,000 in respect of
indebtedness for borrowed money, when and as the same
shall become due and payable, whether at maturity or
upon acceleration, and such indebtedness is not paid,
or such acceleration is not rescinded, by the end of
the 20th day after receipt of notice to us of such
default from the trustee or to us and the trustee from
holders of not less than 33% in aggregate principal
amount of the notes then outstanding; and
(7) certain events of bankruptcy, insolvency or
reorganization of UniSource Energy or TEP.
If an event of default other than an event of default described in
clause (7) above with respect to UniSource Energy occurs and is continuing,
either the trustee or the holders of at least 33% in aggregate principal amount
of the notes then outstanding may declare the principal amount of the notes then
outstanding plus any interest on the notes accrued and unpaid (including
contingent interest and additional interest, if any) through the date of such
declaration to be immediately due and payable.
If an event of default described in clause (7) above with respect to
UniSource Energy occurs, the principal amount of the notes plus accrued and
unpaid interest (including contingent interest and additional interest, if any)
will automatically become immediately due and payable.
At any time after a declaration of acceleration has been made, but
before a judgment or decree for payment of money has been obtained by the
trustee, and subject to applicable law and certain other provisions of the
indenture, the holders of a majority in aggregate principal amount of the notes
then outstanding may, under certain circumstances, rescind and annul such
acceleration.
Subject to the indenture, applicable law and the trustee's
indemnification, the holders of a majority in aggregate principal amount of the
outstanding notes will have the right to direct the time, method and place of
conducting any proceeding for any remedy available to the trustee or exercising
any trust or power conferred on the trustee with respect to the notes.
No holder will have any right to institute any proceeding under the
indenture, or for the appointment of a receiver or a trustee, or for any other
remedy under the indenture unless:
- the holder has previously given the trustee written notice
of a continuing event of default;
- the holders of at least 33% in aggregate principal amount
of the notes then outstanding have made a written request
and have offered indemnity reasonably satisfactory to the
trustee to institute such proceeding as trustee; and
- the trustee has failed to institute such proceeding within
60 days after such notice, request and offer, and has not
received from the holders of a majority in aggregate
principal amount of the notes then outstanding a direction
inconsistent with such request within 60 days after such
notice, request and offer.
However, the above limitations do not apply to a suit instituted by a
holder for the enforcement of payment of the principal of or any interest on any
note on or after the applicable due date or the right to convert the note in
accordance with the indenture.
Generally, the holders of not less than a majority of the aggregate
principal amount of outstanding notes may waive any default or event of default
other than:
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- our failure to pay principal of or any interest (including
contingent interest and additional interest, if any) on any
note when due or the payment of any repurchase price;
- our failure to convert any note into common stock and cash
for fractional shares; and
- our failure to comply with any of the provisions of the
indenture that cannot be modified without the consent of
the holder of each outstanding note.
We are required to furnish to the trustee, on an annual basis, a
statement by our officers as to whether or not we, to the officers' knowledge,
are in default in the performance or observance of any of the terms, provisions
and conditions of the indenture, specifying any known defaults.
CONSOLIDATION, MERGER AND SALE OF ASSETS
We may not consolidate with or merge into any person in a transaction
in which we are not the surviving person or convey, transfer or lease all or
substantially all of our properties and assets to any successor person, unless:
- we are the surviving person or the resulting, surviving or
transferee person, if other than us, is organized and
validly existing under the laws of the United States of
America, any state of the United States, or the District
of Columbia and assumes our obligations on the notes and
under the indenture; and
- immediately after giving effect to the transaction, no
default or event of default shall have occurred and be
continuing.
When such a person assumes our obligations in such circumstances,
subject to certain exceptions, we shall be discharged from all obligations under
the notes and the indenture. Although the indenture permits these transactions,
some of the transactions described above could constitute a fundamental change
of UniSource Energy and permit each holder to require us to repurchase the notes
of such holder as described above under "--Repurchase of Notes at the Option of
Holders-- Repurchase of Notes at the Option of Holders Upon a Fundamental
Change."
MODIFICATION AND WAIVER
Except as described below, we and the trustee may amend or supplement
the indenture or the notes with the consent of the holders of at least a
majority in aggregate principal amount of the outstanding notes. In addition,
subject to certain exceptions, the holders of a majority in aggregate principal
amount of the outstanding notes may waive our compliance in any instance with
any provision of the indenture without notice to the holders. However, no
amendment, supplement or waiver may be made without the consent of the holder of
each outstanding note if such amendment, supplement or waiver would:
(1) change the stated maturity of the principal of or the
payment date of any installment of interest, contingent
interest or additional interest on or with respect to
the notes;
(2) reduce the principal amount of, repurchase price or
redemption price of, the make-whole premium or rate of
interest, contingent interest or additional interest on
any note;
(3) reduce the amount of principal payable upon
acceleration of the maturity of any note;
(4) change the currency in which the principal of,
repurchase price or redemption price or interest with
respect to the notes is payable;
(5) impair the right to institute suit for the enforcement
of any payment on, or with respect to, any note;
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(6) modify the provisions with respect to the repurchase
rights of the holders described under "--Repurchase of
Notes at the Option of Holders--Repurchase of Notes at
the Option of Holders Upon a Fundamental Change" and
"--Optional Put" in a manner adverse to holders;
(7) adversely affect the right of holders to convert notes
other than as provided in the indenture;
(8) reduce the percentage in principal amount of the
outstanding notes, the consent of whose holders is
required in order to take specific actions including,
but not limited to, the waiver of past defaults or the
modification or amendment of the indenture; or
(9) alter the manner of calculation or rate of accrual of
interest, contingent interest or additional interest,
redemption price, repurchase price or the make-whole
premium on any note or extend the time or payment of
any such amount.
We and the trustee may amend or supplement the indenture or the notes
without notice to, or the consent of the holders to, among other things:
(1) cure any ambiguity, defect, omission, mistake or
inconsistency;
(2) provide for uncertificated notes in addition to or in
place of certificated notes;
(3) provide for the assumption of our obligations to
holders of notes in the case of a share exchange,
merger or consolidation or sale of all or substantially
all of our assets;
(4) make any change that would provide any additional
rights or benefits to the holders of notes or that does
not adversely affect in any material respect the legal
rights under the indenture of any such holder;
(5) add a guarantor;
(6) comply with requirements of the SEC in order to effect
or maintain the qualification of the indenture under
the Trust Indenture Act;
(7) secure the notes;
(8) comply with the rules of any applicable securities
depositary, including DTC;
(9) conform the text of the indenture or the notes to any
provision of this description of the notes to the
extent that the text of the indenture or the notes was
intended to be a recitation of the text of this
description of the notes; or
(10) provide for a successor trustee in accordance with the
terms of the indenture or to otherwise comply with any
requirement of the indenture.
SATISFACTION AND DISCHARGE
We may satisfy and discharge our obligations under the indenture by
delivering to the trustee for cancellation all outstanding notes or by
depositing with the paying agent or conversion agent, as the case may be, after
the notes have become due and payable, whether at maturity or any repurchase
date or by delivery of a notice of redemption or conversion or otherwise, cash
or other consideration (as applicable under the terms of the indenture)
sufficient to pay all of the outstanding notes and paying all other sums payable
under the indenture. Such discharge is subject to terms contained in the
indenture.
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CALCULATIONS IN RESPECT OF THE NOTES
We or our agents will be responsible for making all calculations called
for under the notes. These calculations include, but are not limited to,
determination of the trading price of the notes and sale price of our common
stock, the projected payment schedule and the amount of any make-whole premium.
We or our agents will make all these calculations in good faith and, absent
manifest error, our and their calculations will be final and binding on holders
of notes. We or our agents will provide a schedule of these calculations to the
trustee, and the trustee is entitled to conclusively rely upon the accuracy of
these calculations without independent verification.
GOVERNING LAW
The indenture and the notes are governed by, and construed in
accordance with, the laws of the State of New York.
CONCERNING THE TRUSTEE
The Bank of New York is the trustee under the indenture. The trustee
will be the paying agent, conversion agent, registrar and bid solicitation agent
for the notes. The trustee can be contacted at the address set forth below
regarding transfer or conversion of the notes.
If the trustee becomes a creditor of the Company, the indenture limits
the right of the trustee to obtain payment of claims in certain cases, or to
realize on certain property received in respect of any such claims as security
or otherwise. The trustee will be permitted to engage in other transactions; if,
however, it acquires any conflicting interest, it must eliminate such conflict
with 90 days, apply to the SEC for permission to continue as trustee (if the
indenture has been qualified under the Trust Indenture Act) or resign.
BOOK-ENTRY DELIVERY AND FORM
We initially issued the notes in the form of a global security. The
global security was deposited with the trustee as custodian for DTC and
registered in the name of Cede & Co., as DTC's nominee. Except as set forth
below, the global security may be transferred, in whole and not in part, only to
DTC or another nominee of DTC. Holders may hold their beneficial interests in
the global security directly through DTC if they have an account with DTC or
indirectly through organizations that have accounts with DTC. Notes in
definitive certificated form (called "certificated securities") will be issued
only in certain limited circumstances described below.
DTC has advised us that it is:
- a limited purpose trust company organized under the laws of
the State of New York;
- a member of the Federal Reserve System;
- a "clearing corporation" within the meaning of the New York
Uniform Commercial Code; and
- a "clearing agency" registered pursuant to the provisions
of Section 17A of the Exchange Act.
DTC was created to hold securities of institutions that have accounts
with DTC (called "participants") and to facilitate the clearance and settlement
of securities transactions among its participants in such securities through
electronic book-entry changes in accounts of the participants, thereby
eliminating the need for physical movement of securities certificates. DTC's
participants include securities brokers and dealers, which may include the
initial purchasers, banks, trust companies, clearing corporations and certain
other organizations. Access to DTC's book-entry system is also available to
others such as banks, brokers, dealers and trust companies (called the "indirect
participants") that clear through or maintain a custodial relationship with a
participant, whether directly or indirectly.
39
Ownership of beneficial interests in the global security will be
limited to participants or persons that may hold interests through participants.
Ownership of beneficial interests in the global security will be shown on, and
the transfer of those beneficial interests will be effected only through,
records maintained by DTC (with respect to participants' interests), the
participants and the indirect participants. The laws of some jurisdictions may
require that certain purchasers of securities take physical delivery of such
securities in definitive form. These limits and laws may impair the ability to
transfer or pledge beneficial interests in the global security.
Owners of beneficial interests in global securities who desire to
convert their interests into common stock should contact their brokers or other
participants or indirect participants through whom they hold such beneficial
interests to obtain information on procedures, including proper forms and
cut-off times, for submitting requests for conversion.
So long as DTC, or its nominee, is the registered owner or holder of a
global security, DTC or its nominee, as the case may be, will be considered the
sole owner or holder of the notes represented by the global security for all
purposes under the indenture and the notes. In addition, no owner of a
beneficial interest in a global security will be able to transfer that interest
except in accordance with the applicable procedures of DTC. Except as set forth
below, as an owner of a beneficial interest in the global security, holders will
not be entitled to have the notes represented by the global security registered
in their name, will not receive or be entitled to receive physical delivery of
certificated securities and will not be considered to be the owner or holder of
any notes under the global security. We understand that, under existing industry
practice, if an owner of a beneficial interest in the global security desires to
take any action that DTC, as the holder of the global security, is entitled to
take, DTC would authorize the participants to take such action, and the
participants would authorize beneficial owners owning through such participants
to take such action or would otherwise act upon the instructions of beneficial
owners owning through them.
We will make payments of principal of, premium, if any, and any
interest on the notes represented by the global security registered in the name
of and held by DTC or its nominee to DTC or its nominee, as the case may be, as
the registered owner and holder of the global security. We expect that DTC or
its nominee, upon receipt of any payment of principal of, premium, if any, or
additional interest, if any, on the global security, will credit participants'
accounts with payments in amounts proportionate to their respective beneficial
interests in the principal amount of the global security as shown on the records
of DTC or its nominee. We also expect that payments by participants or indirect
participants to owners of beneficial interests in the global security held
through such participants or indirect participants will be governed by standing
instructions and customary practices and will be the responsibility of such
participants or indirect participants. Neither we, the trustee nor any paying
agent or conversion agent will have any responsibility or liability for any
aspect of the records relating to, or payments made on account of, beneficial
interests in the global security for any note or for maintaining, supervising or
reviewing any records relating to such beneficial interests or for any other
aspect of the relationship between DTC and its participants or indirect
participants or the relationship between such participants or indirect
participants and the owners of beneficial interests in the global security
owning through such participants.
Transfers between participants in DTC will be effected in the ordinary
way in accordance with DTC rules and will be settled in same-day funds.
DTC has advised us that it will take any action permitted to be taken
by a holder of notes only at the direction of one or more participants to whose
account the DTC interests in the global security is credited, and only in
respect of such portion of the aggregate principal amount of notes as to which
such participant or participants has or have given such direction. If, however,
DTC notifies us that it is unwilling to be a depository for the global security
or ceases to be a clearing agency, and we do not appoint a successor depositary
within 90 days, or if there is an event of default under the notes, we will
exchange the global security for certificated securities, which we will
distribute to DTC participants and which will be legended, if required, as set
forth under the heading "Transfer Restrictions."
Although DTC is expected to follow the foregoing procedures in order to
facilitate transfers of interests in the global security among participants of
DTC, it is under no obligation to perform or continue to perform such
procedures, and such procedures may be discontinued at any time. Neither we nor
40
the trustee will have any responsibility or liability for the performance by DTC
or the participants or indirect participants of their respective obligations
under the rules and procedures governing their respective operations.
REGISTRATION RIGHTS
We entered into a registration rights agreement with the initial
purchasers pursuant to which we at our cost have, for the benefit of the
holders, filed with the SEC the shelf registration statement, of which this
prospectus is a part, covering the resale of the securities. The following
summary of the registration rights provided in the registration rights agreement
and the notes is not complete. You should refer to the registration rights
agreement for a full description of the registration rights that apply to the
notes.
We agreed to use our commercially reasonable efforts to have shelf
registration statement, of which this prospectus is a part, declared effective
as soon as practicable but not later than 210 days after the first date of
original issuance of the notes, and to keep it effective until the earliest of:
(1) two years from the first date of original issuance of
the notes;
(2) the date when all securities shall have been registered
under the Securities Act and disposed of; and
(3) the date on which all securities held by non-affiliates
are eligible to be sold to the public pursuant to Rule
144(k) under the Securities Act.
If we notify the holders in accordance with the registration rights
agreement upon the occurrence of certain events, then the holders will suspend
the use of the prospectus until the requisite changes have been made and the
period of effectiveness of the shelf registration statement provided for above
shall be extended by the number of days from and including the date of the
giving of such notice to and including the date when holders have received the
amended or supplemented prospectus.
A holder of securities that sells securities pursuant to the shelf
registration statement generally will be required to provide information about
itself and the specifics of the sale, be named as a selling security holder in
the related prospectus, deliver a prospectus to purchasers, be subject to
relevant civil liability provisions under the Securities Act in connection with
such sales and be bound by the provisions of the registration rights agreements
which are applicable to such holder.
If:
(1) the shelf registration statement has not been declared
effective by the SEC by the 210th day after the first
date of original issue of the notes; or
(2) after the shelf registration statement has been
declared effective, such shelf registration statement
ceases to be effective, or the shelf registration
statement or prospectus contained therein ceases to be
usable in connection with the resales of notes and the
common stock issuable upon the conversion of the notes,
in accordance with and during the periods specified in
the registration rights agreement because either (1)
any event occurs as a result of which the prospectus
forming part of such shelf registration statement would
include any untrue statement of a material fact or omit
to state any material fact necessary to make the
statements therein in the light of the circumstances
under which they were made not misleading or (2) it
shall be necessary to amend such shelf registration
statement or supplement the related prospectus, to
comply with the Securities Act or Exchange Act or the
respective rules thereunder.
(we refer to each such event described above in clauses (1) and (2) as a
registration default), additional interest will accrue on the notes, from and
including the date on which the registration default shall occur to but
excluding the date on which all such registration defaults have been cured, at
the rate of 0.50% per year.
41
Notwithstanding the foregoing, after the effectiveness of the shelf
registration statement, we may suspend the availability of the shelf
registration statement and the use of any prospectus by written notice to the
holders for a period or periods not to exceed an aggregate of 45 calendar days
in any 90 calendar day period, and not to exceed 90 calendar days in any twelve
month period (each such period, a "Deferral Period") without incurring such
additional interest if:
(i) an event occurs and is continuing as a result of which the shelf
registration statement or any related prospectus would, in our
good faith judgment, contain an untrue statement of a material
fact or omit to state a material fact necessary in order to make
the statements therein not misleading; and
(ii) (a) we determine in our good faith judgment that the disclosure
of such event at such time would have a material adverse effect
on our business, operations or prospects and such disclosure is
not otherwise required to be made under applicable law or (b) the
disclosure otherwise relates to a pending material business
transaction that has not yet been publicly disclosed.
We will pay all expenses incident to our performance of and compliance
with the registration rights agreement, provide each holder that is selling
securities pursuant to the shelf registration statement copies of the related
prospectus and take other actions as are required to permit, subject to the
foregoing, unrestricted resales of the securities.
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DESCRIPTION OF CAPITAL STOCK
GENERAL
The authorized capital stock of UniSource Energy presently consists of
76,000,000 shares, of which 75,000,000 shares are common stock without par
value, and 1,000,000 shares are preferred stock without par value (Preferred
Stock). As of June 21, 2005, there were 34,701,669 shares of common stock
outstanding and no shares of Preferred Stock outstanding.
The following is a summary of certain rights and privileges of the
holders of the Shares. This summary does not purport to be complete. The
following information is qualified in its entirety by reference to UniSource
Energy's Restated Articles of Incorporation and shareholder rights plan and to
the laws of the State of Arizona.
COMMON STOCK
Dividend Rights. UniSource Energy may pay dividends on shares of common
stock out of any funds legally available for payment, when and as declared by
our Board of Directors. Payment of dividends may be subject to certain
limitations specified with respect to the Preferred Stock, or any series of
Preferred Stock.
Liquidation Rights. In the event of any dissolution or other winding up
of UniSource Energy, whether voluntary or involuntary, the assets of UniSource
Energy available for payment and distribution to shareholders shall be
distributed ratably in accordance with their holdings to the holders of shares
of the common stock. Those distributions may be subject to certain limitations
specified with respect to the Preferred Stock, or any series of Preferred Stock.
Voting Rights. All voting power is vested in the holders of the common
stock, except as otherwise specified with respect to the Preferred Stock, or any
series of Preferred Stock. With respect to the election of directors and each
other matter coming before any meeting of shareholders, each holder of the
common stock shall be entitled to one (1) vote for each share of such stock
outstanding in the name of that holder on the books of UniSource Energy.
Miscellaneous. The common stock has no preemptive or conversion rights
or redemption or sinking fund provisions and the outstanding common stock is
fully paid and non-assessable.
PREFERRED STOCK
Our Board of Directors has authority to divide the Preferred Stock into
series and to determine the designation, preferences, and voting powers of the
shares of each series so established and the restrictions and qualifications
thereof, all to the extent and in the manner provided by law.
PREFERRED SHARE PURCHASE RIGHTS
General. On March 5, 1999, UniSource Energy adopted a shareholder
rights plan. Under that plan, we will grant one preferred share purchase right
(Right) on each outstanding share of common stock to holders of common stock
outstanding on April 1, 1999 or issued thereafter. The description and terms of
the Rights are set forth in the Rights Agreement, dated as of March 5, 1999 (the
Rights Agreement), between UniSource Energy and The Bank of New York, as Rights
Agent. The following statements are qualified in their entirety by reference to
the Rights Agreement.
Each Right will entitle the registered holder, subject to regulatory
approvals and other specified conditions, to purchase one ten-thousandth of a
share of Preferred Stock, Series X, without par value, of UniSource Energy (the
Series X Preferred Stock), at a purchase price of $50.00 (the Purchase Price).
Distribution of Rights. We have distributed one Right to shareholders
of UniSource Energy for each share of common stock owned of record by them at
the close of business on April 1, 1999. Until the earliest of:
- such time as any person or group acquires 15% or more of the
outstanding shares of common stock,
- March 31, 2009 or
- the redemption of the Rights,
we will issue one Right with each share of common stock that is issued after
April 1, 1999 so that all shares of common stock will have attached Rights. We
have initially authorized and reserved 10,000 shares of Preferred Stock for
issuance upon exercise of the Rights.
Exercise. The Rights will be exercisable only if a person or group:
- acquires 15% or more of the outstanding shares of common
stock or
- commences a tender or exchange offer, the consummation of
which would result in the beneficial ownership by a person
or group of 15% or more of the outstanding shares of common
stock.
Until that time the Rights will be evidenced by and will trade with the
shares of common stock. The Rights will expire on March 31, 2009 unless we first
redeem or exchange them, in each case as described below.
The purchase of stock pursuant to the Rights may be subject to
regulatory approval and other specified conditions. Under no circumstance will
the person or group that acquired 15% of the common stock be entitled to
exercise Rights.
"Flip-in." If any person or group acquires 15% or more of the
outstanding shares of common stock, each Right will entitle its holder to
purchase that number of shares of common stock or, at the option of UniSource
Energy, Preferred Stock which has a market value at that time of twice the
Purchase Price.
"Flip-over." In addition, in the event that any person or group has
acquired 15% or more of the outstanding shares of common stock and UniSource
Energy.
- consolidates or merges with or into, or
- sells 50% or more of its assets or earning power to,
any person or group, each Right would instead entitle its holder to purchase the
acquiring company's common shares having a market value of twice the Purchase
Price.
Exchange. If a person or group acquires more than 15% but less than 50%
of the outstanding shares of common stock, we may exchange each outstanding
Right for one share of common stock or cash, securities or other assets having a
value equal to the market value of one share of common stock. That exchange may
be subject to regulatory approval.
Redemption. We may redeem the Rights, at a redemption price of $0.001
per Right, at any time until any person or group has acquired 15% or more of the
outstanding shares of common stock.
Certain Adjustments. The Purchase Price, the amount and type of
securities covered by each Right and the number of Rights outstanding will be
adjusted to prevent dilution:
- in the event of a stock dividend on, or a subdivision,
combination or reclassification of, the Preferred Stock,
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- if holders of the Preferred Stock are granted certain
rights, options or warrants to subscribe for Preferred Stock
or securities convertible into Preferred Stock or equivalent
preferred shares at less than the current market price of
the Preferred Stock, or
- upon the distribution to holders of the Preferred Stock of
evidences of indebtedness or assets (excluding regular
quarterly cash dividends) or of subscription rights or
warrants (other than those referred to above).
With certain exceptions, no adjustments in the Purchase Price will be
made until cumulative adjustments amount to a least 1% of the Purchase Price. We
will not issue fractional shares of Series X Preferred Stock other than in
integral multiples of one ten-thousandth of a share. Instead, we will make an
adjustment in cash based on the market price of the Series X Preferred Stock on
the last trading date prior to the date of exercise.
Amendment. We may amend the Rights Agreement in any respect until any
person or group has acquired 15% or more of the outstanding shares of common
stock. Thereafter, we may amend the Rights Agreement in any manner which will
not adversely affect the holders of the Rights in any material respect.
ARIZONA BUSINESS COMBINATION STATUTE
General.
The Arizona business combination statute would limit our ability to
engage in Business Combinations with Interested Shareholders (each as defined
below).
"Business Combination" means any (A) merger or consolidation of
UniSource Energy or any UniSource Energy subsidiary with an Interested
Shareholder, (B) exchange of shares of UniSource Energy common stock or any
UniSource Energy subsidiary for shares of an Interested Shareholder, or (C)
sale, lease, transfer or other disposition to or with an Interested Shareholder
of 10% or more of the consolidated assets of UniSource Energy.
"Interested Shareholder" means any person other than UniSource Energy
or a UniSource Energy subsidiary that is either (A) a direct or indirect
beneficial owner of 10% or more of the voting power of the outstanding UniSource
Energy common stock or (B) an affiliate of UniSource Energy who at any time
during the three years immediately before the date in question was the
beneficial owner of 10% or more of the voting power of the then outstanding
UniSource Energy common stock.
"Share Acquisition Date" means the date that a person first becomes an
Interested Shareholder of UniSource Energy.
Business Combinations Within Three Years After Share Acquisition Date.
For three years after an Interested Shareholder's Share Acquisition Date,
UniSource Energy may not directly or indirectly engage in any Business
Combination with an Interested Shareholder or any affiliate of an Interested
Shareholder unless, before the Interested Shareholder's Share Acquisition Date,
a committee of disinterested directors approved either:
- the Business Combination; or
- the acquisition of common stock made by the Interested
Shareholder on the Interested Shareholder's Share
Acquisition Date.
Business Combinations More Than Three Years After Share Acquisition
Date. If a committee of disinterested directors has not approved the Business
Combination or the acquisition of common stock as provided above, UniSource
Energy may not directly or indirectly engage in any Business Combination with an
Interested Shareholder or any affiliate of an Interested Shareholder unless:
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- the Business Combination is consummated no earlier than
three years after the Interested Shareholder's Share
Acquisition Date, and before the Share Acquisition Date, the
UniSource Energy Board of Directors approved either
o the Business Combination; or
o the acquisition of common stock made by the Interested
Shareholder on the Share Acquisition Date; or
- the Business Combination is approved no earlier than three
years after the Interested Shareholder's Share Acquisition
Date by the affirmative vote of a majority of the
outstanding voting shares of UniSource Energy common stock
(excluding shares of common stock beneficially owned by the
Interested Shareholder or any affiliate thereof);
- the Business Combination is consummated no earlier than
three years after the Interested Shareholder's Share
Acquisition Date and meets certain specified conditions
designed to ensure against discriminatory pricing.
ARIZONA CONTROL SHARE ACQUISITION STATUTE
General. The Arizona control share acquisition statute would limit the
voting rights of a person who acquires shares of UniSource Energy under certain
circumstances in a control share acquisition (as defined below).
Control Share Acquisition means an acquisition, directly or indirectly
(in one or more transactions within 120 days or pursuant to a plan), by a person
of beneficial ownership of shares of UniSource Energy common stock that would,
but for the limitations in the control share acquisition statute, entitle the
acquiring person to exercise a new range of voting power within the following
specified ranges: (A) at least 20% but less than 33-1/3%, (B) at least 33-1/3%
but less than or equal to 50% and (C) over 50%.
Information Statement. Within ten days after a Control Share
Acquisition, the acquiring person must deliver to the corporation an information
statement specifying, among other things, the range of voting power in the
election of directors that, but for the limitations in the statute, the
acquiring person believes would result from the Control Share Acquisition. At
the time of delivery of the information statement, the acquiring person may
request that a special meeting of shareholders be called to consider the voting
rights of "excess" shares (referred to below).
Limitation on Voting Rights of "Excess" Shares. To the extent that
shares of UniSource Energy common stock acquired in a Control Share Acquisition
exceed the threshold of voting power of any of the next specified range of
voting power, such "excess" shares will have the same voting rights as other
shares of UniSource Energy common stock for election of directors but will not
have the right to vote on other matters unless approved by a shareholder
resolution at an annual or special meeting. Such resolution must be approved by
the affirmative vote of a majority of the outstanding voting shares of UniSource
Energy common stock (excluding shares owned by the acquiring person, its
affiliates or any officer or director of UniSource Energy).
Financing Agreement. The status of voting rights of "excess" shares is
not required to be presented for consideration at any meeting of shareholders
unless, at the time of delivery of the information statement referred to above,
the acquiring person has entered into a definitive financing agreement for any
financing of the acquisition not to be provided by monies of the acquiring
person.
Redemption by UniSource Energy. If an acquiring person fails to deliver
the required information statement within ten days after a Control Share
Acquisition or if the UniSource Energy shareholders have voted not to accord
voting rights to an acquiring person's "excess" shares referred to above, then
UniSource Energy may call for the redemption of such "excess" shares at the fair
market value of those shares at the time the call for redemption is given.
45
ANTITAKEOVER EFFECT
The Rights or the provisions of Arizona Law described above,
individually or collectively, may discourage, deter, delay or impede a tender
offer or other attempt to acquire control of UniSource Energy even if the
transaction would result in the shareholders receiving a premium for their
shares over current market prices or if the shareholders otherwise believe the
transaction would be in their best interests.
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MATERIAL U.S. FEDERAL INCOME TAX CONSIDERATIONS
The following summary describes the material U.S. federal income tax
considerations with respect to the beneficial ownership and disposition of the
notes and our common stock into which the notes may be converted. This summary
deals only with notes held by beneficial owners who hold the notes and our
common stock as capital assets within the meaning of Section 1221 of the
Internal Revenue Code of 1986, as amended ("Code"). The summary does not address
all of the U.S. federal income tax consequences that may be important to
particular beneficial owners in light of their personal circumstances and does
not deal with special situations, such as those of dealers or traders in
securities or currencies, banks, financial institutions, tax exempt
organizations, life insurance companies, real estate investment trusts,
regulated investment companies, certain former citizens or residents of the
U.S., partnerships or other entities classified as partnerships for U.S. federal
income tax purposes, persons holding the notes or our common stock as a part of
a hedging or conversion transaction or a straddle or other risk reduction
transaction, persons who mark to market their securities, or United States
Holders (as defined below) whose functional currency is not the U.S. dollar. In
addition, this discussion does not include any description of any alternative
minimum tax consequences, U.S. federal estate or gift tax consequences or the
tax laws of any state, local or foreign jurisdiction.
The discussion below is based upon the provisions of the Code, Treasury
Regulations promulgated thereunder, and administrative rulings and judicial
decisions, all as of the date hereof, and all of which may be subject to change
at any time, with either forward looking or retroactive effect, so as to result
in U.S. federal income tax consequences different from those discussed below.
No statutory or judicial authority directly addresses the treatment of
the notes or instruments similar to the notes for U.S. federal income tax
purposes. The Internal Revenue Service ("IRS") has issued a revenue ruling with
respect to instruments similar to the notes. To the extent it addresses the
issues, this ruling supports certain aspects of the treatment described below.
No ruling has been or is expected to be sought from the IRS with respect to the
U.S. federal income tax consequences to beneficial owners of the notes. As a
result, no assurance can be given that the IRS will agree with all of the tax
characterizations and the tax consequences described below.
THIS DISCUSSION IS PROVIDED FOR GENERAL INFORMATION ONLY AND DOES NOT
CONSTITUTE LEGAL ADVICE TO ANY POTENTIAL INVESTOR. PERSONS CONSIDERING THE
PURCHASE OF THE NOTES ARE URGED TO CONSULT THEIR TAX ADVISORS WITH REGARD TO THE
APPLICATION OF THE U.S. FEDERAL INCOME TAX LAWS TO THEIR PARTICULAR SITUATIONS
AS WELL AS ANY TAX CONSEQUENCES ARISING UNDER THE LAWS OF ANY STATE, LOCAL OR
FOREIGN TAXING JURISDICTION.
As used herein, a "United States Holder" means a beneficial owner of a
note or our common stock that is a citizen or resident of the U.S., a
corporation or other entity classified as a corporation for U.S. federal income
tax purposes that is created or organized in or under the laws of the U.S. or
any political subdivision thereof, an estate, the income of which is subject to
U.S. federal income taxation regardless of its source, or a trust, (i) the
administration of which is subject to the primary supervision of a court within
the U.S. and for which one or more U.S. persons have the authority to control
all substantial decisions or (ii) that has a valid election in effect under
applicable Treasury Regulations to be treated as a U.S. person. As used herein,
the term "Non-United States Holder" means a beneficial owner of a note or our
common stock that is not a United States Holder, and that is not a partnership
or other entity classified as partnership for U.S. federal income tax purposes.
If a partnership or other entity classified as a partnership for U.S.
federal income tax purposes holds notes or our common stock, the tax treatment
of the partnership and each partner generally will depend on the activities of
the partnership and the status of the partner. Partnerships acquiring notes, and
partners in such partnerships, should consult their tax advisors.
CLASSIFICATION OF THE NOTES
Under the indenture governing the notes, we will agree, and by
acceptance of a beneficial interest in a note, each beneficial owner of a note
will be deemed to have agreed, to treat the notes as indebtedness for U.S.
47
federal income tax purposes that is subject to the Treasury Regulations
governing contingent payment debt instruments ("contingent payment debt
regulations"). Pursuant to the terms of the indenture, we and every holder agree
(in the absence of an administrative determination or judicial ruling to the
contrary) to be bound by our application of the contingent payment debt
regulations to the notes, including our determination of the projected payment
schedule (as described below) and the comparable yield (as described below),
which is the rate at which interest will be deemed to accrue on the notes for
U.S. federal income tax purposes.
No statutory or judicial authority directly addresses the treatment of
the notes or instruments similar to the notes for U.S. federal income tax
purposes. The IRS has issued a revenue ruling with respect to instruments
similar to the notes. However, the ruling is limited to its particular facts,
and the proper application of the contingent payment debt regulations to the
notes is uncertain in a number of respects. No ruling has been or is expected to
be sought from the IRS with respect to the U.S. federal income tax consequences
to the holders of the notes. As a result, no assurance can be given that the IRS
will agree with all of the tax characterizations and the tax consequences
described herein. A different treatment of the notes upon a successful challenge
by the IRS could significantly affect the amount, timing and character of
income, gain or loss with respect to an investment in the notes. Specifically, a
holder might be required to accrue interest at a higher or lower rate, might not
recognize income, gain or loss upon conversion of the notes to common stock,
might recognize capital gain or loss rather than ordinary income or loss upon a
taxable disposition of the notes, might have a longer holding period in our
common stock acquired upon conversion and might have an adjusted tax basis in
the notes or our common stock acquired upon a conversion of a note materially
different than discussed herein. Accordingly, you are urged to consult your tax
advisor regarding the U.S. federal income tax consequences of an investment in
the notes and the applicability of any proposed legislation (and the prospects
of applicable future legislation) as well as with respect to any tax
consequences arising under the laws of any state, local or foreign taxing
jurisdiction.
The remainder of this discussion assumes that the notes will be treated
as indebtedness subject to the contingent payment debt regulations as described
above.
TAX CONSEQUENCES TO UNITED STATES HOLDERS
Interest Accruals on the Notes
Under the contingent payment debt regulations, a United States Holder,
regardless of its method of accounting for U.S. federal income tax purposes,
will be required to accrue interest income on the notes on a constant yield
basis at an assumed yield (the "comparable yield") determined at the time of
issuance of the notes. The comparable yield for the notes is based on the yield
at which we could issue a nonconvertible fixed rate debt instrument with no
contingent payments, but with terms and conditions otherwise similar to those of
the notes. We have determined the comparable yield to be 6.50%, compounded
semi-annually. Accordingly, United States Holders generally will be required to
include interest in taxable income, in each year prior to maturity, in excess of
the stated semi-annual cash interest payable on the notes and any contingent
interest payments actually received in that year.
Solely for purposes of determining the amount of interest income that a
United States Holder will be required to accrue, we are required to construct a
"projected payment schedule" in respect of the notes representing a series of
payments the amount and timing of which would produce a yield to maturity on the
notes equal to the comparable yield. The projected payment schedule includes the
amount of each noncontingent payment and an estimate for each contingent
payment, taking into account the conversion feature. Holders that wish to obtain
the projected payment schedule may do so by submitting a written request for
such information to UniSource Energy Corporation, One South Church Avenue, Suite
100, Tucson, Arizona 85701.
NEITHER THE COMPARABLE YIELD NOR THE PROJECTED PAYMENT SCHEDULE
CONSTITUTES A PROJECTION OR REPRESENTATION BY US REGARDING THE ACTUAL AMOUNT
THAT WILL BE PAID ON THE NOTES, OR THE VALUE AT ANY TIME OF THE COMMON STOCK
INTO WHICH THE NOTES MAY BE CONVERTED. Pursuant to the terms of the indenture,
we and every United States Holder agree (in the absence of an administrative
determination or judicial ruling to the contrary) to be bound by our
determination of the comparable yield and projected payment schedule.
48
It is possible that the IRS could challenge our determination of the
comparable yield and projected payment schedule. The yield, if redetermined as a
result of such a challenge, could be greater or less than the comparable yield
provided by us, and the projected payment schedule could differ materially from
the projected payment schedule we have provided. In such case, the taxable
income of a holder arising from the ownership, sale, exchange, conversion,
redemption or retirement of a note could be increased or decreased.
Based on the comparable yield and the issue price of the notes, a
United States Holder of a note (regardless of its accounting method) will be
required to accrue interest as the sum of the daily portions of interest on the
notes for each day in the taxable year on which the United States Holder holds
the note, adjusted upward or downward to reflect the difference, if any, between
the actual and projected amount of any contingent payments on the notes (as set
forth below). The issue price of the notes is the first price at which a
substantial amount of the notes is sold to the public, excluding sales to bond
houses, brokers or similar persons or organizations acting in the capacity as
underwriters, placement agents or wholesalers (the "issue price"). The issue
price of the notes was determined on March 1, 2005.
The daily portions of interest in respect of a note are determined by
allocating to each day in an accrual period the ratable portion of interest on
the note that accrues in the accrual period. The amount of interest on a note
that accrues in an accrual period is the product of the comparable yield on the
note (adjusted to reflect the length of the accrual period) and the adjusted
issue price of the note as of the beginning of the accrual period. The adjusted
issue price of a note at the beginning of the first accrual period was equal to
its issue price and for any accrual periods thereafter will be (x) the sum of
the issue price of such note and any interest previously accrued thereon
(disregarding any positive or negative adjustments described below) minus (y)
the amount of any noncontingent payment and the amount of any projected
contingent payments on the notes for previous accrual periods.
Amounts treated as interest under the contingent payment debt
regulations are treated as original issue discount for all purposes of the Code.
Adjustments to Interest Accruals on the Notes
In addition to the interest accrual discussed above, a United States
Holder will be required to recognize interest income equal to the amount of the
excess of actual payments over projected payments (a "positive adjustment") in
respect of a note for a taxable year. For this purpose, the payments in a
taxable year include the fair market value of property (including our common
stock) received in that year and also should include any additional interest
received in that year. If a United States Holder receives actual payments that
are less than the projected payments in respect of a note for a taxable year,
the United States Holder will incur a "negative adjustment" equal to the amount
of such difference. This negative adjustment will (i) first reduce the amount of
interest in respect of the note that a United States Holder would otherwise be
required to include in income in the taxable year and (ii) to the extent of any
excess, give rise to an ordinary loss equal to that portion of such excess that
does not exceed the excess of (A) the amount of all previous interest inclusions
under the note over (B) the total amount of the United States Holder's net
negative adjustments treated as ordinary loss on the note in prior taxable
years. Any negative adjustment in excess of the amounts described in (i) and
(ii) will be carried forward to offset future interest income in respect of the
notes or, if there is a negative adjustment carryforward on the note in a
taxable year in which the note is sold, converted, exchanged, redeemed or
retired, to reduce the amount realized on a sale, conversion, exchange,
redemption or retirement of the notes. A net negative adjustment is not subject
to the two percent floor limitation imposed on miscellaneous deductions under
Section 67 of the Code.
Purchase at a Premium or Discount
A United States Holder that purchases a note at a price that is more or
less than the note's adjusted issue price on the date of purchase must
reasonably allocate such difference to the daily portions of interest or
projected payments over the remaining term of the note. If the price paid by a
United States Holder exceeds the note's adjusted issue price, the amount of the
difference allocated to a daily portion of interest or to a projected payment is
treated as a negative adjustment on the date the daily portion accrues or the
payment is made. If the price paid by a United States Holder is less than the
note's adjusted issue price, the amount of the difference allocated to a daily
portion of interest or to a projected payment is treated as a positive
adjustment on the date the daily portion accrues or the payment is made. On the
49
date of such an adjustment, a United States Holder's adjusted tax basis in the
note will be reduced or increased by the amount treated as a negative or
positive adjustment, respectively. United States Holders should consult their
own tax advisors concerning the operation of these rules and the allocation of
purchase price premiums or discounts.
Sale, Conversion, Exchange, Redemption or Retirement of the Notes
Upon a sale, conversion, exchange, redemption or retirement of a note
for cash or our common stock, a United States Holder will generally recognize
gain or loss equal to the difference between the amount realized on the sale,
conversion, exchange, redemption or retirement (including the make whole
premium, if any, and the fair market value of our common stock received, if any)
and such United States Holder's adjusted tax basis in the note. A United States
Holder's adjusted tax basis in a note will generally be equal to the United
States Holder's purchase price for the note, increased by any interest income
previously accrued by the United States Holder (determined without regard to any
positive or negative adjustments to interest accruals described above) and
decreased by the amount of any noncontingent payment and the projected amount of
any contingent payment previously made on the notes to the United States Holder.
A United States Holder generally will treat any gain as ordinary interest
income, and any loss as ordinary loss to the extent of the excess of previous
interest inclusions over the total negative adjustments previously taken into
account as ordinary loss, and the balance as capital loss (which will be
long-term if the note is held for more than one year). The deductibility of
capital losses is subject to limitations. A United States Holder who sells the
notes at a loss that meets certain thresholds may be required to file a
disclosure statement with the IRS.
A United States Holder's tax basis in our common stock received upon a
conversion of a note will equal the then current fair market value of such
common stock. The United States Holder's holding period for the common stock
received will commence on the day immediately following the date of conversion.
Constructive Distributions
The conversion rate is subject to adjustment under certain
circumstances, as described under "Conversion Rate Adjustments." If at any time
we increase the conversion rate of the notes, either at our discretion or
pursuant to the conversion rate adjustment provisions contained in the notes,
the increase may be treated as a constructive distribution to United States
Holders. Furthermore, in certain circumstances, the failure to provide for an
adjustment to the conversion rate may also be treated as a constructive
distribution. Any such constructive distribution would be treated as a taxable
dividend to such holders to the extent of our current or accumulated earnings
and profits (as determined under U.S. federal income tax principles). Therefore,
United States Holders may recognize income in the event of a constructive
distribution in the manner described under "--Tax Consequences to United States
Holders--Taxation of Distributions on our Common Stock" below, even though they
may not receive any cash or property. It is not clear whether a constructive
dividend deemed paid to a United States Holder would be eligible for the
preferential rates of U.S. federal income tax that are applicable to certain
dividends received. It is also unclear whether corporate United States Holders
would be entitled to claim the dividends received deduction with respect to any
such constructive dividends.
Adjustments to the conversion rate made pursuant to a bona fide,
reasonable adjustment formula which has the effect of preventing the dilution of
the interest of the holders of the notes generally will not be considered to
result in a constructive distribution to the United States Holders. Certain of
the possible adjustments under the conversion rate adjustment provisions
contained in the notes may not qualify as being made pursuant to a bona fide
reasonable adjustment formula. Adjustments to the conversion rate due to the
payment of a taxable dividend to our stockholders will be treated as a
constructive distribution. However, adjustments to the conversion rate in the
event of stock dividends or the distribution of rights to subscribe for our
common stock generally will not be considered to result in a constructive
distribution. Moreover, if there is an adjustment or a failure to make an
adjustment to the conversion rate of the notes that increases the proportionate
interest of holders of our common stock in our assets or earnings and profits,
then such increase in the proportionate interest of holders of our common stock
generally will be treated as a constructive distribution to such holders,
taxable as described below.
Taxation of Distributions on Common Stock
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Distributions paid on our common stock received upon conversion of a
note, other than certain pro rata distributions of common shares, will be
treated as a dividend to the extent paid out of current or accumulated earnings
and profits and will be includible in income by the United States Holder and
taxable as ordinary income when received. If a distribution exceeds our current
and accumulated earnings and profits, the excess will be first treated as a
tax-free return of the United States Holder's investment, up to the United
States Holder's tax basis in the common stock. Any remaining excess will be
treated as a capital gain. Dividends received by noncorporate United States
Holders on common stock in tax years beginning on or before December 31, 2008
generally are subject to U.S. federal income tax at lower rates than other types
of ordinary income, subject to certain exceptions. United States Holders should
consult their own tax advisors regarding the implications of these rules in
their particular circumstances.
Sale or Other Disposition of Common Stock
Gain or loss recognized by a United States Holder on the sale or other
disposition of our common stock received upon conversion of a note will be
capital gain or loss for U.S. federal income tax purposes. The amount of the
United States Holder's gain or loss will be equal to the difference between the
United States Holder's tax basis in the common stock disposed of and the amount
realized on the disposition. Such recognized gain or loss will be long-term
capital gain or loss if the holder's holding period for the common stock is more
than one year. Long-term capital gains of noncorporate taxpayers are generally
taxed at a lower maximum marginal tax rate than the maximum marginal tax rate
applicable to ordinary income. The deductibility of net capital losses by
individuals and corporations is subject to limitations. A United States Holder
who sells the stock at a loss that meets certain thresholds may be required to
file a disclosure statement with the IRS.
TAX CONSEQUENCES TO NON-UNITED STATES HOLDERS
Payments on the Notes
All payments on the notes made to a Non-United States Holder, including
any additional interest and a payment in our common stock or cash (including any
make whole premium) pursuant to a conversion, and any gain realized on a sale or
exchange of the notes, will be exempt from U.S. federal income and withholding
tax, provided that:
o the Non-United States Holder (i) does not own, actually or
constructively, 10% or more of the total combined voting
power of all classes of our stock entitled to vote, (ii) is
not a controlled foreign corporation related, directly or
indirectly, to us through stock ownership and (iii) is not a
bank receiving certain types of interest;
o the Non-United States Holder provides, prior to payment, its
name and address, and taxpayer identification number, if
any, and certifies, under penalties of perjury, that it is
not a "United States person" (which certification may be
made on an IRS Form W-8BEN (or successor form));
o such payments are not effectively connected with the conduct
by such Non-United States Holder of a trade or business in
the United States or, if certain treaty provisions apply,
are not attributable to a permanent establishment maintained
by such holder in the United States; and o in the case of
gain realized on the sale, conversion, exchange, redemption
or retirement of the notes (which is treated as ordinary
interest income), we are not, and have not been within the
shorter of the five-year period preceding such sale,
conversion, exchange, redemption or retirement and the
period the Non-United States Holder held the notes, a U.S.
real property holding corporation. Currently, we are
uncertain as to whether we are a U.S. real property holding
corporation for U.S. federal income tax purposes. If we are
or become a U.S. real property holding corporation, any gain
realized on the sale, conversion, exchange, redemption or
retirement of the notes would only be subject to U.S.
51
federal income and, in certain circumstances, withholding
tax if the Non-United States Holder owned, actually or by
attribution, (a) in the case of notes that become regularly
traded on an established securities market, more than 5% of
the notes, or (b) in the case of notes that were not
regularly traded, such notes which, as of any date on which
any notes were acquired by the holder, had a fair market
value greater than the fair market value on that date of 5%
of our common stock.
However, if a Non-United States Holder were deemed to have received a
constructive dividend (see "Tax Consequences to United States
Holders--Constructive Dividends" above), the Non-United States Holder generally
will be subject to U.S. withholding tax at a 30% rate, subject to reduction by
an applicable treaty, on the taxable amount of the dividend. It is possible that
this tax would be withheld from amounts owed to you, including, but not limited
to, interest, shares of our common stock or sales proceeds subsequently paid or
credited to you. A Non-United States Holder who is subject to withholding tax
should consult its own tax advisor as to whether it can obtain a refund for all
or a portion of the withholding tax in such circumstances.
With respect to the second bullet point above, special certification
rules apply to Non-United States Holders that are pass-through entities rather
than corporations or individuals. Prospective investors should consult their tax
advisors regarding the certification requirements for Non-United States Holders.
If a Non-United States Holder cannot satisfy the requirements described
in the bullet points above, payments of interest (including original issue
discount and a payment of stock or cash pursuant to a conversion, redemption or
retirement) will be subject to U.S. withholding tax at the rate of 30%, unless
the Non-United States Holder provides us with a properly executed (1) IRS Form
W-8BEN (or successor form) claiming an exemption from or reduction in
withholding under the benefit of an applicable income tax treaty or (2) IRS Form
W-8ECI (or successor form) stating that interest (including original issue
discount) paid on the notes is not subject to withholding tax because it is
effectively connected with such Non-United States Holder's conduct of a trade or
business in the United States.
If a Non-United States Holder of a note is engaged in a trade or
business in the United States, and if payments on the note are effectively
connected with the conduct of this trade or business (and, if required by a tax
treaty, are attributable to a permanent establishment maintained by such holder
in the United States), the Non-United States Holder, although exempt from U.S.
withholding tax (assuming the certification requirements described above are
met), will generally be taxed in the same manner as a United States Holder (see
"Tax Consequences to United States Holders" above). Such Non-United States
Holders should consult their own tax advisors with respect to other tax
consequences of the ownership of the notes, including the possible imposition of
a 30% branch profits tax (if the Non-United States Holder is a foreign
corporation), subject to reduction by an applicable treaty, on their effectively
connected income.
Distributions on Common Stock
Dividends paid to a Non-United States Holder of our common stock, to
the extent paid out of our current or accumulated earnings and profits (as
determined under U.S. federal income tax principles), generally will be subject
to U.S. withholding tax at a 30% rate, subject to reduction under an applicable
treaty. In order to obtain a reduced rate of withholding, a Non-United States
Holder will be required to provide a properly executed IRS Form W-8BEN
certifying its entitlement to benefits under a treaty. A Non-United States
Holder who is subject to withholding tax should consult its own tax advisor as
to whether it can obtain a refund for all or a portion of the withholding tax in
such circumstances.
If a Non-United States Holder of our common stock is engaged in a trade
or business in the United States, and if the dividends are effectively connected
with the conduct of this trade or business (and, if required by a tax treaty,
are attributable to a permanent establishment maintained by such holder in the
United States), the Non-United States Holder, although exempt from U.S.
withholding tax, will generally be taxed in the same manner as a United States
Holder (see "Tax Consequences to United States Holders" above), except that the
Non-United States Holder will be required to provide a properly executed IRS
Form W-8ECI in order to claim an exemption from withholding tax. These
Non-United States Holders should consult their own tax advisors with respect to
other tax consequences of the ownership of our common stock, including the
possible imposition of a 30% branch profits tax (if the Non-United States Holder
52
is a foreign corporation), subject to reduction by an applicable treaty, on
their effectively connected income.
Sale or Other Disposition of Common Stock
A Non-United States Holder generally will not be subject to U.S.
federal income or withholding tax on gain realized on a sale or other
disposition of the common stock received upon a conversion of a note, unless:
o the gain is effectively connected with the conduct by such
Non-United States Holder of a trade or business in the
United States, and if certain treaty provisions apply, is
attributable to a permanent establishment maintained by such
holder in the United States;
o in the case of a Non-United States Holder who is a
nonresident alien individual, the individual is present in
the United States for 183 or more days in the taxable year
of the disposition and certain other conditions are met; or
o we are or have been a U.S. real property holding corporation
at any time within the shorter of the five-year period
preceding such sale, exchange or disposition and the period
the Non-United States Holder held the common stock.
Currently, we are uncertain as to whether we are a U.S. real property
holding corporation for U.S. federal income tax purposes. If we are or become a
U.S. real property holding corporation and our common stock is and continues to
be regularly traded on an established securities market, in general, only a
Non-United States Holder of common stock who holds or held, actually or by
attribution (at any time during the shorter of the five year period preceding
the date of disposition or the holder's holding period), more than 5% of our
common stock will be subject to U.S. federal income and, in certain
circumstances, withholding tax on the disposition of our common stock in the
same manner as a United States Holder (see "Tax Consequences to United States
Holders" above).
If a Non-United States Holder of our common stock is engaged in a
trade or business in the United States, and if the gain on the sale or other
disposition of our common stock is effectively connected with the conduct of
this trade or business, the Non-United States Holder will generally be taxed in
the same manner as a United States Holder (see "Tax Consequences to United
States Holders" above). In order to claim an exemption from the U.S. withholding
tax, the Non-United States Holder must comply with applicable certification
requirements, which generally include furnishing a properly executed IRS Form
W-8ECI (or any successor form thereto) or a substitute form. These Non-United
States Holders should consult their own tax advisors with respect to other tax
consequences of the disposition of the common stock, including the possible
imposition of a 30% branch profits tax (if the Non-United States Holder is a
foreign corporation), subject to reduction by an applicable treaty, on their
effectively connected income.
BACKUP WITHHOLDING AND INFORMATION REPORTING
Information returns may be filed with the IRS in connection with
payments on the notes, the common stock into which the notes may be converted
and the proceeds from a sale or other disposition of the notes or the common
stock. In addition, copies of these information returns also may be made
available under the provisions of a specific treaty or other agreement to the
tax authorities of the country in which a Non-United States Holder resides.
A United States Holder may be subject to U.S. backup withholding tax on
these payments, currently at the rate of 28%, if it fails to provide its
taxpayer identification number to the paying agent and comply with certification
procedures or otherwise establish an exemption from backup withholding.
A Non-United States Holder generally will not be subject to U.S. backup
withholding tax on these payments provided that such holder certifies as to its
foreign status or otherwise establishes an exemption and, in addition, we or our
agent do not have actual knowledge or reason to know that such holder is a U.S.
person. The certification procedures required of Non-United States Holders to
claim the exemption from withholding tax on certain payments on the notes,
53
described above, will satisfy the certification requirements necessary to avoid
the backup withholding tax as well.
The amount of any backup withholding from a payment will be allowed as
a credit against the holder's U.S. federal income tax liability and may entitle
the holder to a refund, provided that the required information is timely
furnished to the IRS.
54
PLAN OF DISTRIBUTION
We are registering the securities covered by this prospectus to permit
the selling securityholders to conduct public secondary trading of the
securities from time to time after the date of this prospectus. The securities
may be offered and sold under this prospectus only pursuant to the terms of the
registration rights agreement, described in the section of this prospectus
titled "Description of the Notes--Registration Rights." We will not receive any
of the proceeds of the sale by the selling securityholders of the securities
offered by this prospectus.
The selling securityholders may sell all or a portion of the securities
beneficially owned by them and offered by this prospectus from time to time:
o directly; or
o through underwriters, broker-dealers or agents, who may receive
compensation in the form of discounts, commissions or concessions
from the selling securityholders and/or from the purchasers of
the securities for whom they may act as agent.
The securities may be sold in one or more transactions:
o at fixed prices;
o at prevailing market prices at the time of sale;
o at prices related to the prevailing market prices;
o at varying prices determined at the time of sale; and/or
o at negotiated prices.
These prices will be determined by the securityholders or by agreement
between the securityholders and underwriters or dealers, who may receive fees or
commissions in connection with the sale. The aggregate proceeds to the selling
securityholders from the sale of the securities offered by them under this
prospectus will be the purchase price of the securities less discounts and
commissions, if any. The sales described in the preceding paragraph may be
effected in transactions:
o on any national securities exchange or quotation service on which
the securities may be listed or quoted at the time of sale;
o in the over-the-counter market;
o in transactions otherwise than on these exchanges or services or
in the over-the-counter market;
o through the writing of options, including the issuance by the
selling securityholder of derivative securities, whether the
options or such other derivative securities are listed on an
options or other exchange or otherwise;
o through the settlement of short sales; or
o any combination of the foregoing.
These transactions may include block transactions or crosses. Crosses are
transactions in which the same broker acts as an agent on both sides of the
trade.
55
In connection with sales of the securities, the selling securityholders
may:
o enter into hedging transactions with broker-dealers or other
financial institutions, which may in turn engage in short sales
of the securities in the course of hedging positions they assume;
o sell short and deliver the securities to close out short
positions;
o loan or pledge the securities to broker-dealers or other
financial institutions that in turn may sell such securities;
o enter into option or other transactions with broker-dealers or
other financial institutions that require the delivery to the
broker-dealer or other financial institution of the securities,
which the broker-dealer or other financial institution may resell
pursuant to this prospectus; or
o enter into transactions in which a broker-dealer makes purchases
as a principal for resale for its own account or through other
types of transactions.
Each of the selling securityholders reserves the right to accept and,
together with their agents from time to time, to reject, in whole or in part,
any proposed purchase of securities to be made directly or through agents.
To our knowledge, there are currently no plans, arrangements or
understandings between any selling securityholders and any underwriter,
broker-dealer or agent regarding the sale of the securities by the selling
securityholders. Selling securityholders may not sell any, or may not sell all,
of the securities offered by them pursuant to this prospectus. In addition, we
cannot assure you that a selling securityholder will not transfer, devise or
gift the securities by other means not described in this prospectus. In
addition, any securities covered by this prospectus that qualify for sale
pursuant to Rule 144 or Rule 144A of, or Regulation S under, the Securities Act
may be sold under the applicable rule or regulation rather than pursuant to this
prospectus.
The notes were issued and sold in March 2005 in transactions exempt
from the registration requirements of the Securities Act to persons reasonably
believed by the initial purchasers to be "qualified institutional buyers," as
defined in Rule 144A under the Securities Act. Pursuant to the registration
rights agreement, we have agreed to indemnify the initial purchasers of the
notes and each selling securityholder, and each selling securityholder has
agreed to indemnify us against specified liabilities arising under the
Securities Act. The selling securityholders may also agree to indemnify any
broker-dealer or agent that participates in transactions involving sales of the
securities against some liabilities, including liabilities that arise under the
Securities Act.
The selling securityholders and any other person participating in any
distribution under this prospectus will be subject to the Exchange Act. The
Exchange Act rules include, without limitation, Regulation M, which may limit
the timing of purchases and sales of any of the securities by the selling
securityholders and any such other person. In addition, Regulation M of the
Exchange Act may restrict the ability of any person engaged in the distribution
of the securities to engage in market-making activities with respect to the
particular securities being distributed for a period of up to five business days
prior to the commencement of distribution. This may affect the marketability of
securities and the ability of any person or entity to engage in market-making
activities with respect to the securities.
In order to comply with the securities laws of some states, if
applicable, the securities may be sold in these jurisdictions only through
registered or licensed brokers or dealers. In addition, in some states the
securities may not be sold unless they have been registered or qualified for
sale or an exemption from registration or qualification requirements is
available and is complied with.
The selling securityholders and any underwriters, broker-dealers or
agents that participate in the sale of the securities may be "underwriters"
within the meaning of Section 2(11) of the Securities Act. Any discounts,
commissions, concessions or profit they earn on any resale of the shares may be
underwriting discounts and commissions under the Securities Act. Selling
securityholders who are "underwriters" within the meaning of Section 2(11) of
the Securities Act will be subject to the prospectus delivery requirements of
the Securities Act.
56
To the extent required under the registration rights agreement and
applicable law, the specific amount of notes or number of shares to be sold, the
names of the selling securityholders, the respective purchase prices and public
offering prices, the names of any agent, dealer or underwriter, and any
applicable commission or discounts with respect to a particular offer will be
set forth in an accompanying prospectus supplement or a post-effective amendment
to the registration statement of which this prospectus is a part.
Under the registration rights agreement, we have agreed to use our
commercially reasonable efforts to keep the registration statement, of which
this prospectus is a part, effective until the earliest to occur of the
following:
(1) two years from the first date of original issuance of the notes;
(2) the date when all securities shall have been registered under the
Securities Act and disposed of; and
(3) the date on which all securities held by non-affiliates are
eligible to be sold to the public pursuant to Rule 144(k) under
the Securities Act.
We are permitted, under the registration rights agreement, to prohibit
offers and sales of securities pursuant to this prospectus under specified
circumstances and subject to specified conditions for a period not to exceed an
aggregate of 45 calendar days in any 90 calendar day period, and not to exceed
90 days in any 12-month period. During the time periods when use of this
prospectus is suspended, each selling securityholder has agreed not to sell any
of the securities. We also agreed to pay additional amounts to selling
securityholders if the prospectus is unavailable for periods in excess of those
permitted, as provided in the registration rights agreement.
We have agreed to pay substantially all of the expenses incidental to
the registration, offering and sale of the securities to the public other than
commissions, fees and discounts of underwriters, brokers, dealers and agents.
57
LEGAL MATTERS
The validity of the notes offered hereby and of the shares of common
stock issuable upon the conversion thereof will be passed upon for us by Thelen
Reid & Priest LLP, New York, New York, our special counsel, and Vincent Nitido,
Jr., Esq., our Vice President and General Counsel. In giving their opinions,
Thelen Reid & Priest LLP may rely, as to matters of Arizona law, upon the
opinions of Mr. Nitido, and Mr. Nitido may rely, as to matters of New York law,
upon the opinions of Thelen Reid & Priest LLP.
EXPERTS
The financial statements of UniSource Energy as of December 31, 2004
and 2003 and for each of the three years in the period ended December 31, 2004
and management's assessment of the effectiveness of internal control over
financial reporting (which is included in Management's Report on Internal
Control over Financial Reporting) as of December 31, 2004 included in this
prospectus have been so included in reliance on the report(s) of
PricewaterhouseCoopers LLP, an independent registered public accounting firm,
given on the authority of said firm as experts in auditing and accounting.
The financial statements of TEP as of December 31, 2004 and 2003 and
for each of the three years in the period ended December 31, 2004 included in
this prospectus have been so included in reliance on the report of
PricewaterhouseCoopers LLP, an independent registered public accounting firm,
given on the authority of said firm as experts in auditing and accounting.
With respect to the unaudited financial information of UniSource Energy
and TEP for the three-month periods ended March 31, 2005 and 2004, included in
this prospectus, PricewaterhouseCoopers LLP reported that they have applied
limited procedures in accordance with professional standards for a review of
such information. However, their separate report dated May 6, 2005, appearing
herein states that they did not audit and they do not express an opinion on that
unaudited financial information. Accordingly, the degree of reliance on their
report on such information should be restricted in light of the limited nature
of the review procedures applied. PricewaterhouseCoopers LLP is not subject to
the liability provisions of Section 11 of the Securities Act of 1933 for their
report on the unaudited financial information because that report is not a
"report" or a "part" of the registration statement prepared or certified by
PricewaterhouseCoopers LLP within the meaning of Sections 7 and 11 of the
Securities Act.
58
APPENDIX A
--------------------------------------------------------------------------------
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
(Mark One)
[ X ] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2004
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from ______to_______.
Commission Registrant; State of Incorporation; IRS Employer
File Number Address; and Telephone Number Identification Number
----------- ----------------------------- ---------------------
1-13739 UNISOURCE ENERGY CORPORATION 86-0786732
(An Arizona Corporation)
One South Church Avenue, Suite 100
Tucson, AZ 85701
(520) 571-4000
1-5924 TUCSON ELECTRIC POWER COMPANY 86-0062700
(An Arizona Corporation)
One South Church Avenue, Suite 100
Tucson, AZ 85701
(520) 571-4000
SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:
NAME OF EACH EXCHANGE
REGISTRANT TITLE OF EACH CLASS ON WHICH REGISTERED
---------- ------------------- -------------------
UNISOURCE ENERGY COMMON STOCK, NO PAR VALUE AND New York Stock Exchange
CORPORATION PREFERRED SHARE PURCHASE RIGHTS Pacific Exchange
SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT: NONE
Indicate by check mark whether each registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes X No
--- ---
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of each registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act).
UniSource Energy Corporation Yes X No
--- ---
Tucson Electric Power Company Yes No X
--- ---
The aggregate market value of UniSource Energy Corporation voting
Common Stock held by non-affiliates of the registrant was $847,469,716 based on
the last reported sale price thereof on the consolidated tape on June 30, 2004.
At March 11, 2005, 34,545,932 shares of UniSource Energy Corporation Common
Stock, no par value (the only class of Common Stock), were outstanding.
At March 11, 2005, 32,139,555 shares of Tucson Electric Power Company's
common stock, no par value, were outstanding, of which 32,139,434 shares were
held by UniSource Energy Corporation.
Documents incorporated by reference: Specified portions of UniSource Energy
Corporation's Proxy Statement relating to the 2005 Annual Meeting of
Shareholders are incorporated by reference into Part III.
--------------------------------------------------------------------------------
TABLE OF CONTENTS
Definitions v
-- PART I --
Item 1. - Business 1
Overview of Consolidated Business 1
TEP Electric Utility Operations 2
Service Area and Customers 2
Generating and Other Resources 4
Fuel Supply 7
Water Supply 9
Transmission Access 9
Rates and Regulation 11
TEP's Utility Operating Statistics 12
Environmental Matters 13
UNS Gas 14
Service Territory and Customers 14
Gas Supply and Transmission 14
Rates and Regulation 15
UNS Electric 16
Service Territory and Customers 16
Power Supply and Transmission 16
Rates and Regulation 16
Global Solar Energy, Inc. 17
Other 17
Employees 18
SEC Reports Available on UniSource Energy's Website 19
Item 2. - Properties 19
TEP Properties 19
UES Properties 20
Global Solar Properties 21
Item 3. - Legal Proceedings 21
Item 4. - Submission of Matters to a Vote of Security Holders 22
-- PART II --
Item 5. - Market for Registrant's Common Equity, Related
Stockholder Matters, Issuer Purchases of Equity Securities 22
Item 6. - Selected Consolidated Financial Data 23
UniSource Energy 23
TEP 24
Non-GAAP Measures 25
Item 7. - Management's Discussion and Analysis of
Financial Condition and Results of Operations 27
UniSource Energy Consolidated 28
Outlook Strategies 28
Results of Operations 29
Contribution by Business Segment 30
Liquidity and Capital Resources 30
Tucson Electric Power Company 35
Results of Operations 36
Factors Affecting Results of Operations 39
Liquidity and Capital Resources 42
UNS Gas 49
Results of Operations 49
ii
Factors Affecting Results of Operations 50
Liquidity and Capital Resources 50
UNS Electric 52
Results of Operations 52
Factors Affecting Results of Operations 53
Liquidity and Capital Resources 54
Global Solar Energy, Inc. 55
Results of Operations 55
Other 56
Results of Operations 56
Critical Accounting Estimates 58
New Accounting Pronouncements 64
Safe Harbor for Forward-Looking Statements 65
Item 7A. - Quantitative and Qualitative Disclosures about Market Risk 66
Item 8. - Consolidated Financial Statements and Supplementary Data 69
Management's Report on Internal Controls Over Financial
Reporting Under Section 404 of Sarbanes-Oxley 69
Reports of Independent Registered Public Accounting Firm 70
UniSource Energy Corporation
Consolidated Statements of Income 72
Consolidated Statements of Cash Flows 73
Consolidated Balance Sheets 74
Consolidated Statements of Capitalization 75
Consolidated Statements of Changes in Stockholders' Equity 76
Tucson Electric Power Company
Consolidated Statements of Income 77
Consolidated Statements of Cash Flows 78
Consolidated Balance Sheets 79
Consolidated Statements of Capitalization 80
Consolidated Statements of Changes in Stockholders' Equity 81
Notes to Consolidated Financial Statements
Note 1. Nature of Operations and Summary of Significant
Accounting Policies 82
Note 2. Termination of Proposed Acquisition of UniSource Energy 102
Note 3. UniSource Energy Services 102
Note 4. TEP Regulatory Matters 105
Note 5. Accounting Change: Accounting for Asset
Retirement Obligations 109
Note 6. Segment and Related Information 111
Note 7. Accounting for Derivative Instruments, Trading
Activities and Hedging Activities 113
Note 8. Commitments and Contingencies 115
Note 9. Utility Plant and Jointly-Owned Facilities 121
Note 10. Debt and Capital Lease Obligations 123
Note 11. Fair Value of Financial Instruments 126
Note 12. Stockholders' Equity 127
Note 13. TEP Wholesale Accounts Receivable and Allowances 129
Note 14. Springerville Expansion 129
Note 15. Income and Other Taxes 130
Note 16. Employee Benefit Plans 133
Note 17. Stock-Based Compensation Plans 137
Note 18. UniSource Energy Earnings Per Share 139
Note 19. Related Parties 139
Note 20. Supplemental Cash Flow Information 141
Note 21. Quarterly Financial Data (Unaudited) 143
Schedule II - Valuation and Qualifying Accounts 145
Item 9. - Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure 147
Item 9A. - Controls and Procedures 147
iii
Item 9B. - Other Information 147
-- PART III --
Item 10. - Directors and Executive Officers of the Registrants 147
Item 11. - Executive Compensation 149
Item 12. - Security Ownership of Certain Beneficial Owners and Management 150
Item 13. - Certain Relationships and Related Transactions 150
Item 14. - Principal Accountant Fees and Services 150
-- PART IV --
Item 15. - Exhibits and Financial Statements Schedules 151
Signatures 152
Exhibit Index 156
iv
DEFINITIONS
The abbreviations and acronyms used in the 2004 Form 10-K are defined below:
--------------------------------------------------------------------------------
ACC................................. Arizona Corporation Commission.
ACC Holding Company Order........... The order approved by the ACC in
November 1997 allowing TEP to
form a holding company.
AHMSA............................... Altos Hornos de Mexico, S.A.
de C.V. AHMSA owns 50% of Sabinas.
AMT................................. Alternative Minimum Tax.
APS................................. Arizona Public Service Company.
Btu................................. British thermal unit(s).
Capacity............................ The ability to produce power; the most
power a unit can produce or the
maximum that can be taken under a
contract; measured in MWs.
CISO................................ California Independent System
Operator.
Citizens............................ Citizens Communications Company.
Citizens Settlement Agreement....... An agreement with the ACC Staff
dated April 1, 2003, addressing
rate case and financing issues
in the acquisition by UniSource
Energy of the Citizens' Arizona gas
and electric assets.
Common Stock........................ UniSource Energy's common stock,
without par value.
Company or UniSource Energy......... UniSource Energy Corporation.
Cooling Degree Days................. An index used to measure the impact
of weather on energy usage
calculated by subtracting 75
from the average of the high
and low daily temperatures.
CPX................................. California Power Exchange.
Credit Agreement.................... Credit Agreement between TEP and a
syndicate of banks, dated as of
March 25, 2004.
Emissions Allowance(s).............. An allowance issued by the
Environmental Protection Agency
which permits emission of one
ton of sulfur dioxide or one ton of
nitrogen oxide. These allowances can
be bought and sold.
Energy.............................. The amount of power produced over a
given period of time; measured
in MWh.
EPA................................. The Environmental Protection Agency.
ESP................................. Energy Service Provider.
Express Line........................ 345-kV circuit connecting
Springerville Unit 2 to the Tucson
138-kV system.
FAS 71.............................. Statement of Financial Accounting
Standards No. 71: Accounting for
the Effects of Certain Types of
Regulation.
FAS 133............................. Statement of Financial Accounting
Standards No 133: Accounting for
Derivative Instruments and Hedging
Activities, as amended.
FAS 143............................. Statement of Financial Accounting
Standards No. 143: Accounting for
Asset Retirement Obligations.
FERC................................ Federal Energy Regulatory Commission.
First Collateral Trust Bonds........ Bonds issued under the Indenture of
Trust, dated as of August 1, 1998,
of TEP to the Bank of New York,
successor trustee.
First Mortgage Bonds................ First mortgage bonds issued under
the Indenture, dated as of April 1,
1941, of TEP to J.P. Morgan Chase
Bank, successor trustee, as
supplemented and amended.
Four Corners........................ Four Corners Generating Station.
Global Solar........................ Global Solar Energy, Inc., a company
that develops and manufactures
thin-film photovoltaic cells.
Millennium owns 99% of Global Solar.
Haddington.......................... Haddington Energy Partners II, LP, a
limited partnership that funds
energy-related investments.
Heating Degree Days................. An index used to measure the
impact of weather on energy
usage calculated by subtracting
the average of the high and low
daily temperatures from 65.
IDBs................................ Industrial development revenue or
pollution control revenue bonds.
IPS................................. Infinite Power Solutions, Inc., a
company that develops thin-film
batteries. Millennium owns 72%
of IPS.
v
IRS................................. Internal Revenue Service.
ISO................................. Independent System Operator.
ITC................................. Investment Tax Credit.
kWh................................. Kilowatt-hour(s).
kV.................................. Kilovolt(s).
LIBOR............................... London Interbank Offered Rate.
LOC................................. Letter of Credit.
Luna................................ Luna Energy Facility.
MEG................................. Millennium Environment Group, Inc., a
wholly-owned subsidiary of
Millennium, which manages and
trades emission allowances, coal,
and related financial instruments.
MicroSat............................ MicroSat Systems, Inc. is a company
formed to develop and commercialize
small-scale satellites. Millennium
currently owns 35%.
Millennium.......................... Millennium Energy Holdings, Inc.,
a wholly-owned subsidiary of
UniSource Energy.
Mimosa.............................. Minerales de Monclova, S.A. de C.V.,
an owner of coal and associated gas
reserves and a supplier of
metallurgical coal to the steel
industry and thermal coal to the
Mexican electricity commission.
Sabinas owns 19.5% of Mimosa.
MMBtus.............................. Million British Thermal Units.
MW.................................. Megawatt(s).
MWh................................. Megawatt-hour(s).
Navajo.............................. Navajo Generating Station.
NOL................................. Net Operating Loss carryback or
carryforward for income tax
purposes.
PGA................................. Purchased Gas Adjuster, a retail rate
mechanism designed to recover
the cost of gas purchased for
retail gas customers.
PNM................................. Public Service Company of New Mexico.
PNMR................................ PNM Resources.
Powertrusion........................ POWERTRUSION International, Inc.,
a company owned 77% by
Millennium, which manufactures
lightweight utility poles.
PPFAC............................... Purchased Power and Fuel Adjustment
Clause.
PWCC................................ Pinnacle West Capital Corporation.
Revolving Credit Facility........... $60 million revolving credit facility
entered into under the Credit
Agreement between a syndicate of
banks and TEP.
RTO................................. Regional Transmission Organization.
Rules............................... Retail Electric Competition Rules.
Sabinas............................. Carboelectrica Sabinas,
S. de R.L. de C.V., a Mexican
limited liability company.
Millennium owns 50% of Sabinas.
Saguaro Utility..................... An Arizona limited partnership, whose
general partner is Sage
Mountain, L.L.C. and whose limited
partners include investment
funds affiliated with Kohlberg
Kravis Roberts & Co., L.P.,
J.P. Morgan Partners, L.L.C. and
Wachovia Capital Partners.
San Carlos.......................... San Carlos Resources Inc.,
a wholly-owned subsidiary of TEP.
San Juan............................ San Juan Generating Station.
Second Mortgage Bonds............... TEP's second mortgage bonds issued
under the Indenture of Mortgage
and Deed of Trust, dated as of
December 1, 1992, of TEP to the Bank
of New York, successor trustee, as
supplemented.
Sempra.............................. Sempra Energy Trading Company.
SCE................................. Southern California Edison Company.
SES................................. Southwest Energy Solutions, Inc., a
wholly-owned subsidiary of
Millennium.
Springerville....................... Springerville Generating Station.
Springerville Coal Handling
Facilities Leases.............. Leveraged lease arrangements relating
to the coal handling facilities
serving Springerville.
Springerville Common
Facilities..................... Facilities at Springerville used in
common with Springerville Unit 1
and Springerville Unit 2.
Springerville Common
Facilities Leases.............. Leveraged lease arrangements
relating to an undivided
one-half interest in certain
Springerville Common Facilities.
vi
Springerville Unit 1................ Unit 1 of the Springerville
Generating Station.
Springerville Unit 1 Lease.......... Leveraged lease arrangement relating
to Springerville Unit 1 and an
undivided one-half interest in
certain Springerville Common
Facilities.
Springerville Unit 2................ Unit 2 of the Springerville
Generating Station.
SRP................................. Salt River Project Agricultural
Improvement and Power District.
Sundt............................... H. Wilson Sundt Generating Station
(formerly known as the Irvington
Generating Station).
Sundt Lease......................... The leveraged lease arrangement
relating to Sundt Unit 4.
SWG................................. Southwest Gas Corporation.
TEP................................. Tucson Electric Power Company,
the principal subsidiary of
UniSource Energy.
TEP Settlement Agreement............ TEP's Settlement Agreement approved
by the ACC in November 1999 that
provided for electric retail
competition and transition asset
recovery.
Therm............................... A unit of heating value equivalent to
100,000 British thermal units (Btu).
Tri-State........................... Tri-State Generation and Transmission
Association.
TruePricing......................... TruePricing, Inc., a start-up company
established to market energy
related products.
UED................................. UniSource Energy Development Company,
a wholly-owned subsidiary of
UniSource Energy, which engages in
developing generation resources and
other project development services
and related activities.
UES................................. UniSource Energy Services, Inc., an
intermediate holding company
established to own the operating
companies (UNS Gas and UNS Electric)
which acquired the Citizens Arizona
gas and electric utility assets.
UniSource Energy.................... UniSource Energy Corporation.
UNS Electric........................ UNS Electric, Inc., a wholly-owned
subsidiary of UES, which acquired
the Citizens Arizona electric
utility assets.
UNS Gas............................. UNS Gas, Inc., a wholly-owned
subsidiary of UES, which acquired
the Citizens Arizona gas utility
assets.
Valencia............................ Valencia power plant owned by UNS
Electric.
WestConnect......................... The proposed for-profit RTO in
which TEP is a participant.
vii
PART I
This Annual Report on Form 10-K contains forward-looking statements as
defined by the Private Securities Litigation Reform Act of 1995. You should read
forward-looking statements together with the cautionary statements and important
factors included in this Form 10-K. (See Item 7. - Management's Discussion and
Analysis of Financial Condition and Results of Operations, Safe Harbor for
Forward-Looking Statements). Forward-looking statements include statements
concerning plans, objectives, goals, strategies, future events or performance
and underlying assumptions. Forward-looking statements are not statements of
historical facts. Forward-looking statements may be identified by the use of
words such as "anticipates," "estimates," "expects," "intends," "plans,"
"predicts," "projects," and similar expressions. We express our expectations,
beliefs and projections in good faith and believe them to have a reasonable
basis. However, we make no assurances that management's expectations, beliefs or
projections will be achieved or accomplished. In addition, UniSource Energy and
TEP disclaim any obligation to update any forward-looking statements to reflect
events or circumstances after the date of this report.
ITEM 1. - BUSINESS
--------------------------------------------------------------------------------
OVERVIEW OF CONSOLIDATED BUSINESS
---------------------------------
UniSource Energy is a holding company that has no significant operations of
its own. Operations are conducted by UniSource Energy's subsidiaries, each of
which is a separate legal entity with its own assets and liabilities. UniSource
Energy owns substantially all of the outstanding common stock of TEP, and all of
the outstanding common stock of UniSource Energy Services, Inc. (UES),
Millennium Energy Holdings, Inc. (Millennium), and UniSource Energy Development
Company (UED).
TEP, an electric utility, has provided electric service to the community of
Tucson, Arizona, for over 100 years. UES began operations in August 2003. UES
through its two operating subsidiaries, UNS Gas and UNS Electric, provides gas
and electric service to 30 communities in northern and southern Arizona.
Millennium invests in unregulated businesses, including Global Solar Energy
(Global Solar), a developer and manufacturer of thin-film photovoltaic cells and
modules. UED engages in developing generating resources and other project
development activities, including facilitating the expansion of the
Springerville Generating Station, but has no significant operations. We conduct
our business in four primary business segments - TEP's Electric Utility segment,
UNS Gas, UNS Electric and Global Solar.
UniSource Energy was incorporated in the State of Arizona on March 8, 1995
and obtained regulatory approval to form a holding company in November 1997. On
January 1, 1998, TEP and UniSource Energy exchanged shares of stock resulting in
TEP becoming a subsidiary of UniSource Energy. Following the share exchange, TEP
transferred the stock of its subsidiary Millennium to UniSource Energy. See Note
10 of Notes to Consolidated Financial Statements - Debt and Capital Lease
Obligations.
TERMINATION OF MERGER AGREEMENT
In November 2003, UniSource Energy entered into an Agreement and Plan of
Merger (the Agreement) with Saguaro Acquisition Corp. (Saguaro), an affiliate of
Saguaro Utility Group L.P. (Saguaro LP) that provided for the acquisition of all
of UniSource Energy's outstanding common stock for $25.25 per share by Saguaro.
Saguaro LP was an Arizona limited partnership whose general partner was Sage
Mountain, L.L.C. and whose limited partners included investment funds associated
with Kohlberg Kravis Roberts & Co., L.P., J.P. Morgan Partners, LLC and Wachovia
Capital Partners.
On December 21, 2004, the Arizona Corporation Commission (ACC) voted, at
the end of a special open meeting, not to approve the application seeking its
approval of the proposed acquisition.
The Agreement provided that in the event that the ACC denied the
acquisition, Saguaro or UniSource Energy could terminate the Agreement, and
UniSource Energy would be obligated to reimburse up to $7 million of Saguaro's
expenses. On December 30, 2004, Saguaro exercised its right to terminate the
Agreement and UniSource Energy paid Saguaro $7 million to cover Saguaro's
expenses, pursuant to the terms of the Agreement.
BUSINESS SEGMENT CONTRIBUTIONS
K-1
The table below shows the contributions to our consolidated after-tax
earnings by our four business segments.
2004 2003 2002
-------------------------------- -------------- ---------------- --------------
-Millions of Dollars-
BUSINESS SEGMENT
TEP (1) $ 46 $ 129 $ 55
UNS Gas (2) 6 1 -
UNS Electric (2) 4 2 -
Global Solar (5) (7) (14)
Other (3) (5) (11) (6)
-------------------------------- -------------- ---------------- --------------
Consolidated Net Income $ 46 $ 114 $ 35
================================ ============== ================ ==============
(1) TEP results in 2003 include an after-tax gain of $67 million for the
Cumulative Effect of Accounting Change from the adoption of Statement of
Financial Accounting Standards No. 143, Accounting for Asset Retirement
Obligations (FAS 143).
(2) 2003 results are for the period from August 11, 2003 to December 31,
2003.
(3) Includes: interest expense (net of tax) on the note that was payable
from UniSource Energy to TEP; costs in 2003 associated with the Citizens
acquisition; costs associated with the failed acquisition of UniSource
Energy as previously discussed; UniSource Energy parent company expenses;
income and losses from Millennium's investments other than Global Solar;
income and losses from UED.
The electric utility industry has undergone significant regulatory change
in recent years. See Item 7. - Management's Discussion and Analysis of Financial
Condition and Results of operations, Outlook and Strategies, for a discussion of
our plans and strategies to remain competitive and flexible in this changing
environment and Rates and Regulation, below, for the status of competition in
Arizona.
References in this report to "we" and "our" are to UniSource Energy and its
subsidiaries, collectively.
TEP ELECTRIC UTILITY OPERATIONS
-------------------------------
TEP was incorporated in the State of Arizona on December 16, 1963. TEP is
the successor by merger as of February 20, 1964, to a Colorado corporation that
was incorporated on January 25, 1902. TEP is the principal operating subsidiary
of UniSource Energy. In 2004, TEP's electric utility operations contributed 76%
of UniSource Energy's operating revenues and comprised 84% of its assets.
SERVICE AREA AND CUSTOMERS
TEP is a vertically integrated utility that provides regulated electric
service to more than 375,000 retail customers in Southeastern Arizona. TEP's
service territory consists of a 1,155 square mile area and includes a population
of approximately 931,000 in the greater Tucson metropolitan area in Pima County,
as well as parts of Cochise County. TEP holds a franchise to provide electric
distribution service to customers in the Cities of Tucson and South Tucson.
These franchises expire in 2026 and 2017, respectively. TEP also sells
electricity to other utilities and power marketing entities in the western U.S.
RETAIL CUSTOMERS
In 2004, TEP's number of retail customers increased by 2.3% and total
retail energy consumption increased by approximately 3.2%. The table below shows
the percentage distribution of TEP's energy sales by major customer class over
the last three years.
2004 2003 2002
---------------------------- --------------- ---------------- ----------------
Residential 40% 41% 40%
Commercial 21% 20% 20%
Non-mining Industrial 26% 27% 28%
Mining 10% 9% 9%
Public Authority 3% 3% 3%
---------------------------- --------------- ---------------- ----------------
K-2
TEP expects that its peak demand, number of retail customers and retail
energy consumption will increase 2 - 3% annually through 2008. The retail energy
consumption by customer class through 2008 is expected to be similar to the 2004
distribution.
Beginning January 1, 2001, all of TEP's retail customers were eligible to
choose alternative energy providers. Continued regulatory developments and legal
challenges to the retail electric competition rules have raised uncertainty
about the status and pace of retail competition in Arizona. Even though some of
TEP's retail customers may choose other energy providers, the forecasted
customer growth rates referred to above would continue to apply to its
distribution business. At March 11, 2005, none of TEP's customers are being
served by an alternative energy provider. See Rates and Regulation, State,
below.
SALES TO LARGE INDUSTRIAL CUSTOMERS
TEP provides electric utility service to a diverse group of commercial,
industrial, and public sector customers. Major industries served include copper
mining, cement manufacturing, defense, health care, education, military bases
and other governmental entities. Local, regional, and national economic factors
can impact the financial condition and operations of TEP's large industrial
customers. Such economic conditions may directly impact energy consumption by
large industrial customers, and may indirectly impact residential and small
commercial sales and revenues if employment levels and consumer spending are
affected.
Two of TEP's largest retail customers are in the copper mining industry.
TEP has contracts with its two mining customers to provide electric service at
negotiated rates. These contracts expire in 2006 and 2008. TEP's sales to mining
customers depend on a variety of factors including changes in supply and demand
in the world copper market and the economics of self-generation. Average U.S.
copper prices have ranged between $0.63 and $1.46 per pound during the last five
years. As a result of low copper prices in 2002 and 2003, TEP's mining customers
reduced operations during those years and correspondingly reduced energy
consumption. Since October 2003, U.S. copper prices have risen steadily and
averaged approximately $1.47 per pound in February 2005. Higher copper prices
have led to increased mining operations and kWh sales to TEP's mining customers.
WHOLESALE BUSINESS
TEP's electric utility operations include the wholesale marketing of
electricity to other utilities and power marketers. Wholesale sales transactions
are made on both a firm and interruptible basis. A firm basis means that
contractually, TEP must supply the power (except under limited emergency
circumstances), while an interruptible basis means that TEP may stop supplying
power under defined conditions. See Other Purchases and Interconnections, below.
TEP typically uses its own generation to serve the requirements of its
retail and long-term wholesale customers. Generally, TEP commits to future sales
based on expected excess generating capability, forward prices and generation
costs, using a diversified portfolio approach to provide a balance between
long-term, and mid-term and spot energy sales. When TEP expects to have excess
generating capacity and energy (usually in the first, second and fourth calendar
quarters), its wholesale sales consist primarily of three types of sales:
(1) Sales under long-term contracts for periods of more than one year. TEP
currently has long-term contracts with three entities to sell firm
capacity and energy: Salt River Project Agricultural Improvement and
Power District (SRP), which expires in May 2011, the Navajo Tribal
Utility Authority, which expires in December 2009, and the Tohono
O'odham Utility Authority, which expires in August 2009. TEP also has
a multi-year interruptible contract with Phelps Dodge Energy Services,
which expires in February 2006 and requires a fixed contract demand of
60 MW at all times except during TEP's peak customer energy demand
period, from July through September of each year. Under the contract,
TEP can interrupt delivery of power if TEP experiences significant
loss of any electric generating resources.
(2) Other sales include forward sales and short-term sales. Under forward
contracts, TEP commits to sell a specified amount of capacity or
energy at a specified price over a given period of time, typically for
one-month, three-month or one-year periods. Under short-term sales,
TEP sells energy in the daily or hourly markets at fluctuating spot
market prices and makes other non-firm energy sales.
(3) Sales of transmission service.
K-3
TEP purchases power in the wholesale markets when economic. TEP may enter
into forward contracts: (a) to purchase energy under long-term contracts to
serve retail load and long-term wholesale contracts, (b) to purchase capacity or
energy during periods of planned outages or for peak summer load conditions, and
(c) to purchase energy to resell to certain wholesale customers under load and
resource management agreements. Finally, TEP may purchase energy in the daily
and hourly markets to meet higher than anticipated demands, to cover unplanned
generation outages, or when it is more economical than generating its own
energy.
In 2003, both the natural gas and western U.S. wholesale electricity
markets experienced some price spikes and volatility due to severe winter
weather. Gas and power prices remained high throughout 2004 due to continued gas
production and storage concerns. TEP cannot predict, however, whether gas and
wholesale electricity prices will remain elevated and what the impact will be on
TEP's sales and revenues in the future.
TEP expects to continue to be a participant in the wholesale energy
markets, primarily by making sales and purchases in the short-term and forward
markets. TEP expects the market price in the western U.S. and demand for
capacity and energy to continue to be influenced by the following factors, among
others, during the next few years:
o continued population growth;
o economic conditions in the western U.S.;
o availability of generation capacity throughout the western U.S.;
o the extent of electric utility restructuring in Arizona, California
and other western states;
o the effect of FERC regulation of wholesale energy markets;
o the availability and price of natural gas;
o the availability of hydropower;
o transmission constraints; and
o environmental requirements and the cost of compliance.
See Item 7. - Management's Discussion and Analysis of Financial Condition
and Results of Operations, Tucson Electric Power Company, Factors Affecting
Results of Operations, Western Energy Markets, for additional discussion of
TEP's wholesale marketing activities.
GENERATING AND OTHER RESOURCES
TEP GENERATING RESOURCES
At December 31, 2004, TEP owned or leased 2,004 MW of net generating
capability as set forth in the following table:
NET
UNIT FUEL OWNED/ CAPABILITY OPERATING TEP'S SHARE
GENERATING SOURCE NO. LOCATION TYPE LEASED MW AGENT % MW
-----------------------------------------------------------------------------------------------------------------------------------
Springerville Station 1 Springerville, AZ Coal Leased 380 TEP 100.0 380
Springerville Station 2 Springerville, AZ Coal Owned 380 TEP 100.0 380
San Juan Station 1 Farmington, NM Coal Owned 327 PNM 50.0 164
San Juan Station 2 Farmington, NM Coal Owned 316 PNM 50.0 158
Navajo Station 1 Page, AZ Coal Owned 750 SRP 7.5 56
Navajo Station 2 Page, AZ Coal Owned 750 SRP 7.5 56
Navajo Station 3 Page, AZ Coal Owned 750 SRP 7.5 56
Four Corners Station 4 Farmington, NM Coal Owned 784 APS 7.0 55
Four Corners Station 5 Farmington, NM Coal Owned 784 APS 7.0 55
Sundt Station 1 Tucson, AZ Gas/Oil Owned 81 TEP 100.0 81
Sundt Station 2 Tucson, AZ Gas/Oil Owned 81 TEP 100.0 81
Sundt Station 3 Tucson, AZ Gas/Oil Owned 104 TEP 100.0 104
Sundt Station 4 Tucson, AZ Coal/Gas Leased 156 TEP 100.0 156
Internal Combustion Turbines Tucson, AZ Gas/Oil Owned 122 TEP 100.0 122
Internal Combustion Turbines Tucson, AZ Gas Owned 95 TEP 100.0 95
Solar Electric Generation Springerville/ Solar Owned 5 TEP 100.0 5
Tucson, AZ
-----------------------------------------------------------------------------------------------------------------------------------
Total TEP Capacity (1) 2,004
===================================================================================================================================
K-4
(1) Excludes 454 MW of additional resources, which consist of certain capacity
purchases and interruptible retail load. At December 31, 2004, total owned
capacity was 1,468 MW and leased capacity was 536 MW.
The Springerville Generating Station, located in northeast Arizona,
consists of two coal-fired units. Springerville Unit 1 began commercial
operation in 1985 and is leased and operated by TEP. Springerville Unit 2
started commercial operation in June 1990 and is owned by TEP's wholly-owned
subsidiary, San Carlos Resources Inc. (San Carlos), and operated by TEP. These
units are rated at 380 MW for continuous operation. The Springerville Station
was originally designed for four generating units. Unit 3 will be 100% leased by
a financial owner to Tri-State Generation and Transmission Association
(Tri-State). Construction of Unit 3 began in October 2003. We expect commercial
operation of Unit 3 to occur in the third quarter of 2006. TEP will operate the
unit. Salt River Project (SRP) has the right to construct and own Unit 4 at a
later date. See UniSource Energy Development Company, below.
The Springerville Generating Station also includes the Springerville Coal
Handling Facilities and the Springerville Common Facilities. In 1984, TEP sold
and leased back the Springerville Coal Handling Facilities. In 1985, TEP sold
and leased back a 50% interest in the Springerville Common Facilities. The other
50% interest is included in the Springerville Unit 1 leases.
TEP obtains approximately 600 MW, or 30% of its generating capacity from
jointly-owned facilities at the San Juan, Four Corners, and Navajo Generating
Stations in New Mexico and northern Arizona.
The Sundt Generating Station (Sundt) includes four units located in Tucson,
Arizona. Units 1, 2 and 3 are gas or oil burning units. Sundt Unit 4 operates
primarily on coal in combination with natural gas or landfill gas, but it is
also able to operate solely on natural gas. Units 1, 2, and 3 are wholly-owned
by TEP, and Unit 4 is leased. The Sundt Generating Station and the internal
combustion turbines located in Tucson are designated as "must-run generation"
facilities. Must-run generation units are those which are required to run in
certain circumstances to maintain distribution system reliability and meet local
load requirements.
See Note 10 of Notes to consolidated Financial Statements, and Item 7. -
Management's Discussion and Analysis of Financial Condition and Results of
Operations, Tucson Electric Power Company, Liquidity and Capital Resources,
Contractual Obligations, for more information regarding the Springerville and
Sundt leases.
POWER EXCHANGE AGREEMENTS
TEP and Southern California Edison Company (SCE) have a power exchange
agreement which expires on May 14, 2005. The agreement required SCE to provide
firm system capacity of 110 MW to TEP during the summer months and for TEP to
return to SCE in the winter months the same amount of energy that TEP received
during the preceding summer. The net incremental increase in cost due to the
loss of the SCE exchange agreement is expected to be less than $2 million
annually.
On January 28, 2005, TEP entered into an exchange agreement with Sempra
Energy Trading Company (Sempra). TEP will provide firm system capacity of 40 MW
to Sempra during February through May 2005. Sempra will then provide TEP with
firm system capacity of 50 MW during June through September 2005.
OTHER PURCHASES AND INTERCONNECTIONS
TEP purchases additional electric energy from other utilities and power
marketers. The amount of energy purchased varies substantially from time to time
depending on the demand for energy, the cost of purchased energy compared with
TEP's cost of generation and the availability of such energy. TEP may also sell
electric energy in the wholesale market.
In 2003, as part of the ACC's Track B competitive energy bidding process,
TEP entered into two power purchase agreements for the period 2003 through 2006
as listed below:
o PPL Energy Plus, LLC supplied 37 MW from June 2003 through December
2003 and supplies 75 MW from January 2004 through December 2006, under
a unit contingent contract between TEP and PPL Energy Plus, LLC.
o Panda Gila River generating station supplies 50 MW on-peak for the
June through September time period, from 2003 (which has been
supplied) through 2005, under a unit contingent contract between TEP
and Panda Gila River, L.P.
K-5
In January 2005, TEP entered into a separate supply agreement with Panda
Gila River. TEP will purchase 50 MW of firm energy during June through September
2005.
TEP is a member of various regional reserve sharing, reliability and power
sharing organizations. These relationships allow TEP to call upon other
utilities during emergencies such as plant outages and system disturbances, and
reduce the amount of reserves TEP is required to carry.
We believe these and other short-term purchases will provide adequate
reserve margins during the summer peak period. See also Wholesale Business,
above and Item 7. - Management's Discussion and Analysis of Financial Condition
and Results of Operations, Tucson Electric Power Company, Factors Affecting
Results of Operations, below.
PEAK DEMAND AND RESOURCES
PEAK DEMAND 2004 2003 2002 2001 2000
-------------------------------------------------------------------
-MW-
Retail Customers - Net One Hour 2,088 2,060 1,899 1,840 1,862
Firm Sales to Other Utilities 187 171 228 151 143
------------------------------------------------------------------------------------------------------------------------------------
Coincident Peak Demand (A) 2,275 2,231 2,127 1,991 2,005
Total Generating Resources 2,004 2,003 2,002 1,999 1,904
Other Resources (1) 454 486 308 217 248
------------------------------------------------------------------------------------------------------------------------------------
Total TEP Resources (B) 2,458 2,489 2,310 2,216 2,152
Total Margin (B) - (A) 183 258 183 225 147
Reserve Margin (% of Coincident Peak Demand) 8% 12% 9% 11% 7%
------------------------------------------------------------------------------------------------------------------------------------
(1) Other Resources include firm power purchases and interruptible retail and
wholesale loads.
TEP's retail sales are influenced by several factors, including seasonal
weather patterns, competitive conditions and the overall economic climate. The
peak demand occurs during the summer months due to the cooling requirements of
TEP's retail customers. Retail peak demand has grown at an average annual rate
of approximately 3% from 2000 to 2004.
The chart above shows the relationship over a five-year period between
TEP's peak demand and its energy resources. TEP's margin is the difference
between total energy resources and coincident peak demand, and the reserve
margin is the ratio of margin to coincident peak demand. TEP maintains a minimum
reserve margin in excess of 7% to comply with reliability criteria set forth by
the Western Electricity Coordinating Council (WECC, formerly the Western Systems
Coordinating Council). TEP's actual reserve margin in 2004 was 8%.
Forecasted retail peak demand for 2005 is approximately 2,144 MW, compared
with actual peak demand of 2,088 MW in 2004. Except for certain peak hours
during the summer, TEP believes it has sufficient resources to meet expected
demand in 2005 with its existing generation capacity and power purchase
agreements.
FUTURE GENERATING RESOURCES -- TEP
In the past, TEP assessed its need for future generating resources based on
the premise of a continued regulatory requirement to serve customers in TEP's
retail service area. However, the ACC's electric competition rules modified the
obligation to provide generation services to all customers. These rules and
TEP's ability to retain and attract customers will affect the need for future
resources. For those customers who do not choose other energy providers, TEP
remains obligated to supply energy. However, TEP is not obligated to supply this
energy from TEP-owned generating assets. The energy may be acquired through
purchases in the wholesale markets. Continued regulatory developments and a
recent Arizona Court of Appeals decision invalidating certain portions of the
ACC rules on retail competition and related market pricing, have raised
uncertainty about the status and pace of retail competition in Arizona. See
Rates and Regulation, Recent Arizona Court of Appeals Decision below and Item 7.
- Management's Discussion and Analysis of Financial Condition and Results of
Operations, Tucson Electric Power Company, Factors Affecting Results of
Operations, Competition, below.
K-6
LUNA ENERGY FACILITY
On November 12, 2004, TEP, Phelps Dodge Energy Services, LLC and PNM
Resources, Inc. (PNMR) each purchased from Duke Energy North America, LLC a
one-third interest in a limited liability company which owned the partially
constructed natural gas-fired Luna Energy Facility (Luna). In February 2005,
most of the assets of the limited liability company were transferred to the new
owners so that each owner directly owns a one-third interest in the plant. Luna,
located in southern New Mexico, is designed as a 570-MW combined cycle plant and
is expected to be operational by the summer of 2006. Luna is expected to provide
TEP with 190 MW of power to serve its wholesale and retail customers. Public
Service Company of New Mexico, an affiliate of PNMR, will oversee the completion
of construction of Luna, which is approximately 50 percent complete, and will
operate Luna.
TEP paid $13 million for its one-third interest. TEP expects to spend up to
an additional $33 million for its one-third share of the costs to complete
construction of Luna and purchase necessary inventory items, of which $30
million will be spent in 2005 and the remainder in 2006. In addition, TEP
expects to spend $3 million for its share of the capital expenditures related to
an anticipated outage in 2009. TEP anticipates that internal cash flows will
fund its share of the costs related to the plant.
PEAKING RESOURCES
TEP will continue to add peaking resources in the Tucson area as needed
based upon our forecasts of retail and firm wholesale load, as well as the
statewide transmission infrastructure. TEP currently forecasts that additional
peaking resources of 150 MW may be needed in both 2010 and 2013.
SPRINGERVILLE UNIT 3
In conjunction with the expansion of the Springerville Generating Station,
TEP entered into a power purchase contract with Tri-State for up to 100 MW of
capacity from Tri-State's system resources. This contract with Tri-State is for
up to five years, beginning with commercial operation of Unit 3, expected in the
third quarter of 2006. TEP anticipates that any power purchased under this
contract will be sold in the wholesale markets.
FUEL SUPPLY
TEP purchases coal and natural gas in the normal course of business to fuel
its generating plants. The majority of its coal supplies are purchased under
long-term contracts, which result in more predictable prices.
Fuel information is provided below on a delivered to the boiler basis:
AVERAGE COST PER MMBTU PERCENTAGE OF TOTAL BTU
CONSUMED CONSUMED
-------------------------------------------------------------------------------
2004 2003 2002 | 2004 2003 2002
|
Coal (A) $ 1.57 $ 1.58 $ 1.59 | 96% 96% 94%
Gas $ 6.75 $ 6.38 $ 4.28 | 4% 4% 6%
All Fuels $ 1.79 $ 1.79 $ 1.76 | 100% 100% 100%
-------------------------------------------------------------------------------
(A) The average cost per ton of coal for 2004, 2003, and 2002 was $30.20,
$30.31, and $30.86, respectively.
TEP'S COAL AND GAS SUPPLY
TEP's principal fuel for electric generation is low-sulfur, bituminous or
sub-bituminous coal from mines in Arizona, New Mexico and Colorado. Four
Corners, Navajo and San Juan Stations are mine mouth generating stations located
adjacent to the coal reserves. The coal supply for Springerville requires
approximately 200 miles of railroad transportation, while the coal supply for
Sundt is approximately 1,300 miles away. All of the contracts for coal and rail
contain price adjustment provisions that are expected to increase the prices at
a rate less than the expected growth of inflation.
Year Average
Contract Sulfur
Station Coal Supplier Terminates Content Coal Obtained From (A)
----------------------------------------------------------------------------------------------------------
Springerville Peabody Coalsales Company 2020 0.9% Lee Ranch Coal Company
Four Corners BHP Billiton 2016 0.8% Navajo Indian Tribe
San Juan San Juan Coal Company 2017 0.8% Federal and State Agencies
Navajo Peabody Coalsales Company 2011 0.6% Navajo and Hopi Indian Tribes
Sundt Various approved suppliers 2006 - Various locations
----------------------------------------------------------------------------------------------------------
K-7
(A) Substantially all of the suppliers' mining leases extend at least as long as
coal is being mined in economic quantities.
TEP OPERATED GENERATING FACILITIES
TEP is the sole owner (or lessee) and operator of the Springerville and
Sundt Unit 4 Generating Stations. The coal supplies for these plants are
transported from northwestern New Mexico and Colorado by railroad.
In October 2003, TEP amended and extended the long-term coal supply
contract for Springerville Units 1 and 2 through 2020. TEP expects coal reserves
to be sufficient to supply the estimated requirements for Units 1 and 2 for
their presently estimated remaining lives. During the extension period of 2011
through 2020, the coal price will be determined by the cost of Powder River Coal
delivered to Springerville for Unit 3. TEP estimates future minimum annual
payments under this contract to be $45 million through 2010, the initial
contract expiration date, and $14 million from 2011 through 2020. TEP's coal
transportation contract at Springerville runs through 2011. TEP estimates
minimum annual payments under this contract to be $13 million through 2010 and
$7 million in 2011.
In the fourth quarter of 2003, TEP entered into agreements for the purchase
and transportation of coal to Sundt Unit 4 through 2006. The total amount paid
under these agreements depends on the number of tons of coal purchased and
transported. The coal purchase agreement requires TEP to take 335,000 tons
annually with estimated future minimum payments of $6 million in each of 2005
and 2006. The rail agreement requires TEP to transport 325,000 tons with
estimated future minimum payments of $3 million in each year through 2006.
The long-term BNSF rail contract for Sundt Unit 4 is in effect until the
earliest of 2015 or the remaining life of Unit 4. This rail contract requires
TEP to transport at least 75,000 tons of coal per year through 2015 at an
estimated annual cost of $2 million or to make a minimum payment of $1 million.
TEP expects to use the rail contracts for at least the minimum delivery amounts
through at least 2006. See Item 7. - Management's Discussion and Analysis of
Financial Condition and Results of Operations, UniSource Energy Consolidated,
Contractual Obligations and Note 8 of Notes to Consolidated Financial Statements
- Commitments and Contingencies, TEP Commitments, Purchase and Transportation
Commitments.
GENERATING FACILITIES OPERATED BY OTHERS
TEP also participates in jointly-owned generating facilities at Four
Corners, Navajo and San Juan, where coal supplies are under long-term contracts
administered by the operating agents. In July 2003, the Four Corners coal
contract was extended through July 2016. This contract requires TEP to purchase
minimum amounts of coal at an estimated annual cost of $5 million for the next
13 years. TEP expects coal reserves available to these three jointly-owned
generating facilities to be sufficient for the remaining lives of the stations.
In September 2000, TEP terminated the San Juan Generating Station's coal
supply contract and entered into a new coal supply contract, replacing two
surface mining operations with one underground operation. San Juan Coal Company,
the coal supplier to San Juan, commenced development of the underground mine in
the fourth quarter of 2000. The underground mine did not achieve full station
supply until December 2003 due to geological issues. PNM, TEP and San Juan Coal
Company have begun a review of long term coal cost projections given the
production issues encountered and the experience gained from mining operations.
The contracts to purchase coal for use at the jointly-owned facilities
require TEP to purchase minimum amounts of coal at an estimated average annual
cost of $19 million for the next five years.
NATURAL GAS
TEP typically uses generation from its facilities fueled by natural gas and
purchased power, in addition to energy from its coal-fired facilities, to meet
the summer peak demands of its retail customers and local reliability needs.
Some of these purchased power contracts are price indexed to natural gas prices.
Short-term and spot power purchase prices are also closely correlated to natural
gas prices. Due to its increasing seasonal gas and purchased power usage, TEP
hedges a portion of its total natural gas exposure from plant fuel, gas-indexed
purchased power and spot market purchases with fixed price contracts for a
maximum of three years. TEP purchases its remaining gas fuel needs and purchased
power in the spot and short-term markets.
K-8
TEP entered into a Gas Procurement Agreement with Southwest Gas Corporation
(SWG) effective June 1, 2001 with a primary term of five years. The contract
provides for a minimum annual volume obligation of 4 million MMBtu's for 2004
and 2005. In 2004, TEP purchased approximately 5.2 million MMBtu's and expects
to use more than the minimum in 2005. In the event fewer MMBtu's are purchased,
TEP is obligated to pay only the transportation component for any shortfall. TEP
made payments under this contract of $34 million in 2004, $34 million in 2003
and $33 million in 2002. In 2004, the average transportation cost per MMBtu was
$0.43 based on the volume of gas purchased by TEP, for a total of $2 million in
transportation costs.
In 2004, the average market price of natural gas at the Permian basin was
$5.44 per MMBtu, or 10% higher than 2003, due to low gas storage levels and gas
production concerns. The increase in the regional supply of gas-generated energy
and the completion of a 500-kV transmission connection, however, allowed TEP to
decrease use of its less efficient gas generation units in favor of more
economical purchases of energy in the wholesale market.
TEP's generation output fueled by natural gas was approximately 427,000
MWh, or 4% of total generation and purchased power in 2004 and 433,000 MWh, or
4% of total generation and purchased power in 2003. In 2004, TEP purchased a
total of 1,400,000 MWh of energy, or 11% of total generation and purchased
power, of which approximately 175,000 MWh were from gas-index priced energy
under long-term purchased power contracts with the remainder being from
short-term and spot power markets. See Rates and Regulation, State, Track B,
below for discussion of purchased power contracts.
WATER SUPPLY
Drought conditions in the Four Corners region, combined with water usage in
upper New Mexico, have resulted in decreasing water levels in the lake that
indirectly supplies water to the San Juan and Four Corners Generating Stations.
These conditions may affect the water supply of the plants in the future if
adequate moisture is not received in the watershed that supplies the area.
Although the moisture levels in the region during the 2004-2005 winter seasons
have been above historic averages, drought conditions persist. TEP has a 50%
ownership interest in each of San Juan units 1 and 2 (322 MW capacity) and a 7%
ownership interest in each of Four Corners units 4 and 5 (110 MW capacity).
PNM, the operating agent for San Juan, has negotiated supplemental water
contracts with the U.S. Bureau of Reclamation and the Jicarilla Apache Nation to
assist San Juan in meeting its water requirements in the event of a water
shortage.
Drought conditions in northern New Mexico and Colorado, combined with
increased water usage in Arizona, Nevada and southern California, have also
caused water levels to significantly recede at Lake Powell, which supplies
operating water for the Navajo Generating Station. If Lake Powell's water level
continues to recede, it will be necessary to lower the water intakes for Navajo.
TEP's share of the expected total cost is approximately $2 million based on its
7.5% ownership interest in Navajo Units 1, 2, and 3 (168 MW capacity).
SRP, the operating agent for Navajo, is monitoring the water levels at Lake
Powell. SRP will initiate the process of lowering Navajo's intakes if and when
it believes there is a reasonable chance that decreasing water levels will move
below the current intake level and interfere with plant operations.
TEP does not believe that its operations will be materially affected by
this drought. However, TEP cannot predict the ultimate length of the drought, or
whether it will adversely affect the amount of power available from the San
Juan, Four Corners and Navajo Generating Stations.
TRANSMISSION ACCESS
TEP has transmission access and power transaction arrangements with over
120 electric systems or suppliers. In May 2003, TEP completed construction of a
one mile 500-kV transmission line and related substations to enhance its
distribution system link to the regional high voltage transmission system north
of Tucson. This line improved system reliability and alleviated a bottleneck
that constrained power delivery to southern Arizona.
TUCSON TO NOGALES TRANSMISSION LINE
In January 2001, TEP and Citizens (now UES) entered into a project
development agreement for the joint construction of a 62-mile transmission line
from Tucson to Nogales, Arizona. This project was initiated by Citizens (now
K-9
UES) in response to an order by the ACC to improve reliability to its retail
customers in Nogales, Arizona. TEP is currently seeking approvals for the
project from the ACC, the Department of Energy (DOE), the U.S. Forest Service,
the U.S. Bureau of Land Management, and the International Boundary and Water
Commission.
The ACC approved the location and construction of the proposed 345-kV line
in January 2002. The DOE has completed a Final Environmental Impact Statement
(EIS) for the project in which it would accept any of the routes in the EIS but,
the U.S. Forest Service has indicated the Central route as its preferred
alternative, rather than the Western Corridor route, which was approved by the
ACC in 2002. As a result, the ACC has ordered TEP to re-open the state line
siting process. The ACC has also ordered TEP to investigate and engage in
discussions with ACC staff and intervenors regarding potential alternatives to
the line.
The DOE will use the EIS to help it decide whether to issue a Presidential
Permit that would allow TEP to extend the line across the border into Mexico.
The U.S. Forest Service will use the EIS to determine whether to grant a land
use permit for the project. Other federal agencies will also use the EIS for
their own permitting processes.
The future costs of construction to Nogales, Arizona are expected to be
approximately $76 million. Through December 31, 2004, approximately $10 million
in land acquisition, engineering and environmental expenses have been
capitalized related to this project. If TEP receives the required approvals in
2005 or early 2006, the forecasted capital expenditures for completing the
transmission line are: $3 million in 2005; $34 million in 2006; $37 million in
2007; and $2 million in 2008. If TEP does not receive the required approvals, it
may be required to expense $8 million of the costs that have been capitalized
related to the project, propose alternative methods to the ACC for approving
reliability and spend additional amounts to implement such alternatives. The
expenditures related to alternative methods for improving reliability are
expected to be less than $76 million.
REGIONAL AND FEDERAL TRANSMISSION ISSUES
In December 1999, the FERC issued FERC Order 2000, which established
timelines for all transmission owning entities to join a Regional Transmission
Organization (RTO) and defined the minimum characteristics and functions of an
RTO. TEP and three other southwestern utilities filed agreements and operating
protocols with the FERC in October 2001 to form a new, for-profit RTO to be
known as WestConnect RTO, LLC (WestConnect). In 2005, four other utilities
joined WestConnect.
WestConnect will be responsible for security, reservations, scheduling,
transmission expansion and planning, and congestion management for the regional
transmission system. It will also focus on ensuring reliability,
nondiscriminatory open-access, and independent governance. Regional transmission
owners would have the option, but not be required, to transfer ownership of
transmission assets to the RTO. At present, TEP intends to turn over only
operating control of its transmission assets to the RTO. Additionally, the RTO
may build new transmission lines in the region, which could be owned by the RTO.
In October 2002, the FERC issued a provisional order approving, in part,
the WestConnect RTO proposal. The FERC also required WestConnect, along with the
other two RTOs in the western region (the California Independent System Operator
(CISO) and RTO West), to participate in a steering group to encourage the
development of a seamless wholesale electric energy market. WestConnect's
operation is dependent on the resolution of these issues and is also subject to
approval by state regulatory agencies. WestConnect is following a phased
approach for development that will progress from development of a regional Open
Access Same Time Information System (OASIS) to full RTO implementation in three
or four phases. The first phase includes the regional OASIS (to be called
WesTTrans) that became operational in early 2004. The WesTTrans system includes
the WestConnect participants as well as some other entities throughout the west
that are outside of the WestConnect footprint. WestConnect is currently
developing future phasing plans.
On July 31, 2002, the FERC issued a Notice of Proposed Rulemaking (NOPR)
proposing standard market design rules that would significantly alter the
markets for wholesale electricity and transmission and ancillary services in the
U.S. The new rules would establish a generation adequacy requirement for
"load-serving entities" and a standard platform for the sale of electricity and
transmission services. Under the new rules, Independent Transmission Providers
would administer spot markets for wholesale power, ancillary services and
transmission congestion rights, and electric utilities, including TEP, would be
required to transfer control over transmission facilities to the applicable
Independent Transmission Provider. This effort by FERC provoked extensive
response from the industry as well as state regulators.
K-10
RATES AND REGULATION
The FERC and the ACC regulate portions of TEP's utility accounting
practices and electricity rates. The FERC regulates the terms and prices of
TEP's transmission services and sales of electricity at wholesale. In 1996, TEP
filed a tariff at FERC governing the rates, terms and conditions of open access
transmission services. In 1997, TEP was granted a FERC tariff to sell power at
market based rates. The ACC has authority over rates charged to retail
customers, the issuance of securities, and transactions with affiliated parties.
STATE
Historically, the ACC determined TEP's rates for retail sales of electric
energy on a "cost of service" basis, which was designed to provide, after
recovery of allowable operating expenses, an opportunity to earn a reasonable
rate of return on TEP's "fair value rate base." Fair value rate base was
generally determined by reference to the original cost and the reconstruction
cost (net of depreciation) of utility plant in service to the extent deemed used
and useful, and to various adjustments for deferred taxes and other items, plus
a working capital component. Over time, rate base was increased by additions to
utility plant in service and reduced by depreciation and retirements of utility
plant.
TEP'S SETTLEMENT AGREEMENT AND RETAIL ELECTRIC COMPETITION RULES
In September 1999, the ACC approved the Retail Electric Competition Rules
(Rules) that provided a framework for the introduction of retail electric
competition in Arizona. In November 1999, the ACC approved the Settlement
Agreement between TEP and certain customer groups related to the implementation
of retail electric competition in Arizona. See Item 7. - Management's Discussion
and Analysis of Financial Condition and Results of Operations, Tucson Electric
Power Company, Rates, for more information.
During 2002, the ACC reexamined circumstances that had changed since it
approved the Rules in 1999. The outstanding issues were divided into two groups.
Track A related primarily to the divestiture of generation assets while Track B
related primarily to the competitive energy bidding process.
TRACK A
In September 2002, the ACC issued the Track A Order, which eliminated the
requirement in the TEP Settlement Agreement that TEP transfer its generation
assets to a subsidiary. As a result, generation assets remain at TEP. At the
same time, the ACC ordered the parties, including TEP, to develop a competitive
bidding process, and reduced the amount of power to be acquired in the
competitive bidding process to only that portion not supplied by TEP's existing
resources.
TRACK B
In February 2003, the ACC issued the Track B Order, which defined the
competitive bidding process TEP must use to obtain capacity and energy
requirements beyond what is supplied by TEP's existing resources for the period
2003 through 2006. TEP estimated these amounts to be 50,000 MWh of energy in
2003, or approximately 0.5% of its retail load, gradually increasing to 104,000
MWh by 2006. The Track B Order further required TEP to bid out "Economy Energy",
or short-term energy purchases, that it estimates it will make in the 2003 to
2006 period (210,000 to 181,000 MWh).
TEP was also required to bid out its Reliability Must Run (RMR) generation
requirements, which are currently met by its existing local generation units.
TEP's RMR generation requirements were estimated at 471 MW of capacity and
37,000 MWh of energy in 2003 increasing to 687 MW of capacity and 38,000 MWh of
energy in 2005.
TEP was not required to purchase any power through this process that it
deems to be uneconomical, unreasonable or unreliable. The Track B bidding
process involved the ACC Staff and an independent monitor. The Track B Order
also confirmed that it is not intended to change the current retail rates for
generation services. TEP entered into two agreements to meets its 2003 bid
requirements under the Track B Order for the period 2003 through 2006.
The Track B Order set forth the requirements of the 2003 competitive
solicitation. The Track B Order did not address TEP's purchased power or asset
acquisitions occurring subsequent to the 2003 competitive solicitation.
K-11
See Generating and Other Resources, Other Purchases and Interconnections,
above.
ARIZONA COURT OF APPEALS DECISION INVALIDATING CERTAIN RETAIL ELECTRIC
COMPETITION RULES
In January 2005, an Arizona Court of Appeals decision became final in which
the Court held invalid certain portions of the ACC rules on retail competition
and related market pricing. Based on this decision, we expect that the ACC will
address the competition rules in an administrative proceeding during 2005. We
cannot predict what changes, if any, the ACC will make to the competition rules.
See Note 4 of the Notes to Consolidated Financial Statements - TEP
Regulatory Matters, for more information on TEP's Settlement Agreement.
TEP'S UTILITY OPERATING STATISTICS
For Years Ended December 31,
2004 2003 2002 2001 2000
------------------------------------------------------------------------------------------------------------------------------------
Generation and Purchased Power - kWh (000)
Remote Generation (Coal) 10,159,729 10,182,706 10,067,069 10,362,211 10,278,393
Local Tucson Generation (Oil, Gas & Coal) 1,174,500 1,082,058 1,402,504 1,820,783 1,667,308
Purchased Power 1,322,084 1,153,305 1,329,574 3,656,978 3,174,244
------------------------------------------------------------------------------------------------------------------------------------
Total Generation and Purchased Power 12,656,313 12,418,069 12,799,147 15,839,972 15,119,945
Less Losses and Company Use 821,008 778,285 791,852 747,941 688,226
------------------------------------------------------------------------------------------------------------------------------------
Total Energy Sold 11,835,305 11,639,784 12,007,295 15,092,031 14,431,719
====================================================================================================================================
Sales - kWh (000)
Residential 3,459,750 3,389,744 3,181,030 3,159,504 3,041,446
Commercial 1,787,472 1,689,014 1,605,148 1,591,942 1,503,222
Industrial 2,226,314 2,245,340 2,254,174 2,297,476 2,272,285
Mining 829,028 701,638 692,448 1,053,152 1,145,891
Public Authorities 240,426 250,038 256,867 257,155 259,621
------------------------------------------------------------------------------------------------------------------------------------
Total - Electric Retail Sales 8,542,990 8,275,774 7,989,667 8,359,229 8,222,465
Electric Wholesale Sales 3,292,315 3,364,010 4,017,628 6,732,802 6,209,254
------------------------------------------------------------------------------------------------------------------------------------
Total Electric Sales 11,835,305 11,639,784 12,007,295 15,092,031 14,431,719
====================================================================================================================================
Operating Revenues (000)
Residential $ 315,402 $ 309,807 $ 291,390 $ 285,808 $ 279,067
Commercial 186,625 175,559 168,838 166,139 158,309
Industrial 161,338 160,276 161,749 162,523 162,888
Mining 38,549 28,022 28,072 41,940 48,460
Public Authorities 17,427 17,839 18,672 18,763 18,883
------------------------------------------------------------------------------------------------------------------------------------
Total - Electric Retail Sales 719,341 691,503 668,721 675,173 667,607
Electric Wholesale Sales 159,918 151,030 157,108 921,280 359,814
Other Revenues 10,039 9,018 8,618 8,508 3,908
------------------------------------------------------------------------------------------------------------------------------------
Total Operating Revenues $ 889,298 $ 851,551 $834,447 $1,604,961 $1,031,329
====================================================================================================================================
Customers (End of Period)
Residential 341,870 334,131 326,847 318,976 311,673
Commercial 32,923 32,369 31,767 31,194 30,467
Industrial 676 676 695 705 711
Mining 2 2 2 2 2
Public Authorities 61 61 61 61 61
------------------------------------------------------------------------------------------------------------------------------------
Total Retail Customers 375,532 367,239 359,372 350,938 342,914
====================================================================================================================================
Average Retail Revenue per kWh Sold (cents)
Residential 9.1 9.1 9.2 9.0 9.2
Commercial 10.4 10.4 10.5 10.4 10.5
Industrial and Mining 6.5 6.4 6.4 6.1 6.2
Average Retail Revenue per kWh Sold 8.4 8.4 8.4 8.1 8.1
Average Revenue per Residential Customer $ 933 $ 937 $ 902 $ 906 $ 906
Average kWh Sales per Residential Customer 10,231 10,249 9,842 10,015 9,878
K-12
ENVIRONMENTAL MATTERS
TEP is subject to environmental regulation of air and water quality,
resource extraction, waste disposal and land use by federal, state and local
authorities. TEP believes that all existing generating facilities are in
compliance with all existing regulations and will be in compliance with expected
environmental regulations, except as described below.
The 1990 Federal Clean Air Act Amendments (CAAA) require reductions of
sulfur dioxide (SO2) and nitrogen oxide (NOx) emissions in two phases. TEP is
subject to only Phase II of the SO2 and NOx emission reductions, which became
effective January 1, 2000. All of TEP's generating facilities (except 142 MW of
its internal combustion turbines) are affected.
EMISSION ALLOWANCES
In 1993, TEP's generating units affected by Phase II were allocated SO2
Emission Allowances based on past operational history. Each allowance gives the
owner the right to emit one ton of SO2. Beginning in 2000, generating units
subject to Phase II must hold Emission Allowances equal to the level of
emissions in the compliance year or pay penalties and offset excess emissions in
future years. TEP had sufficient Emission Allowances to comply with the Phase II
SO2 regulations for compliance years 2003 and 2004. TEP expects to continue to
have adequate Emission Allowances until Springerville Unit 3 goes into service.
At that point, due to reduced usage of Emission Allowances at Springerville Unit
1 and Unit 2, TEP expects to have excess Emission Allowances. Potential changes
to the allocation of SO2 allowances may impact these expectations in future
years.
Title V of the CAAA requires that all of TEP's generating facilities obtain
more complex air quality permits. All TEP facilities (including those jointly
owned and operated by others) have obtained these permits. In 1999, TEP received
Title V permits for the Springerville and Sundt generating stations. These
permits are valid for five years, and, as a result, TEP has submitted a permit
renewal application. TEP must pay an annual emission-based fee for each
generating facility subject to a Title V permit. These emission-based fees are
included in the CAAA compliance expenses discussed below. The CAAA also requires
multi-year studies of visibility impairment in specified areas and studies of
hazardous air pollutants. The results of these studies will impact the
development of future regulation of electric utility generating units. Since
these activities involve the gathering of information not currently available,
TEP cannot predict the outcome of these studies.
STATE REGULATION
Arizona and New Mexico have adopted regulations restricting the emissions
from existing and future coal, oil and gas-fired plants. These regulations are
in some instances more stringent than those adopted by the Environmental
Protection Agency (EPA). The principal generating units of TEP are located
relatively close to national parks, monuments, wilderness areas and Indian
reservations. Since these areas have relatively high air quality, TEP could be
subject to control standards that relate to the "prevention of significant
deterioration" of visibility and tall stack limitation rules. In addition, the
ACC mandated under the Environmental Portfolio Standard (EPS) that TEP derive a
percentage of its total retail energy sold from new solar resources or
environmentally-friendly renewable electricity technologies. The percentage
changes each year, increasing to a maximum of 1.1 percent in 2007. In 2004, the
percentage was 0.8 percent of which at least 60 percent must be derived from
solar electric generation. See Note 8. Commitments and Contingencies, TEP
Contingencies, Litigation and Claims Related to San Juan Generating Station.
MERCURY EMISSIONS
The EPA has issued a determination that coal and oil-fired electric utility
steam generating units must control their mercury emissions. On March 15, 2005,
the EPA adopted regulations relating to mercury emissions under Section 111 of
the Clean Air Act. Additional rule-making procedures will take place at the
state level prior to implementation of the new regulations. TEP is analyzing the
potential impact of the regulations on its operations. Until these state
procedures are adopted, TEP cannot determine if it will be significantly
affected. If TEP is not allocated sufficient allowances for its current
emissions, it may have to purchase additional allowances on the market, or
implement additional controls to reduce emissions.
CAPITAL AND OPERATING COSTS
TEP capitalized $9 million in 2004, $11 million in 2003 and $8 million in
2002 in construction costs to comply with environmental requirements and expects
to capitalize $1 million in 2005 and $1 million in 2006. In addition, TEP
recorded expenses of $9 million in 2004, $8 million in 2003 and $6 million in
2002 and 2001 related to environmental compliance, including the cost of lime
used to scrub the stacks. TEP expects environmental expenses to be $8 million in
K-13
2005. TEP may incur additional costs to comply with recent and future changes in
federal and state environmental laws, regulations and permit requirements at
existing electric generating facilities. Compliance with these changes may
result in a reduction in operating efficiency.
In order to meet Title V permit requirements in connection with the
construction of Springerville Unit 3, the Unit 3 project will pay for
approximately $90 million of capital expenditures related to pollution control
equipment upgrades on Springerville Unit 1 and Unit 2. See Note 8. Commitments
and Contingencies, TEP Contingencies, Springerville Generating Station
Complaint.
UNS GAS
-------
On August 11, 2003, UniSource Energy completed the purchase of the Arizona
gas and electric system assets from Citizens for a total of $223 million,
comprised of the base purchase price plus other operating capital adjustments
and transaction costs. UES was formed to hold the common stock of UNS Gas and
UNS Electric, which operate these gas and electric system assets, respectively.
SERVICE TERRITORY AND CUSTOMERS
UNS Gas is a gas distribution company serving approximately 133,000 retail
customers in Mohave, Yavapai, Coconino, and Navajo Counties in northern Arizona,
as well as Santa Cruz County in southeast Arizona. These counties comprise
approximately 50% of the territory of the state of Arizona, with a population of
approximately 727,000 in 2004.
UNS Gas' customer base is primarily residential. Total revenues derived
from residential customers were approximately 60% in 2004, while sales to other
retail customer classes accounted for approximately 28% of total revenues.
Approximately 12% of total revenues in 2004 were derived from gas transportation
services and a Negotiated Sales Program (NSP). UNS Gas is supplying natural gas
transportation service to the 600 MW Griffith Power Plant located near Kingman,
Arizona, under a 20-year contract which expires in 2021. UNS Gas also supplies
natural gas to some of its large transportation customers, through an NSP
approved by the ACC. One half of the margin earned on these NSP sales is
retained by UNS Gas, while the other half benefits retail customers through a
credit to the purchased gas adjustor (PGA) mechanism which reduces the gas
commodity price.
GAS SUPPLY AND TRANSMISSION
UNS Gas has a natural gas supply and management agreement with BP Energy
Company (BP). Under the contract, BP manages UNS Gas' existing supply and
transportation contracts and its incremental requirements. The initial term of
the agreement extends through August 31, 2005. The term of the agreement is
automatically extended for one year on an annual basis unless either party
provides 180 days notice of its intent to terminate. The market price for gas
supplied by BP will vary based upon the period during which the commodity is
delivered. UNS Gas hedges its gas supply prices by entering into a fixed price
forward contracts at various times during the year to provide more stable prices
to its customers. These purchases are made up to three years in advance with the
goal of hedging at least 45% and not more than 80% of the expected monthly gas
consumption with fixed prices prior to entering into the month. UNS Gas hedged
approximately 60% of its expected monthly consumption for the 2004/2005 winter
season (November through March). Additionally, UNS Gas has approximately 50% of
its expected gas consumption hedged for April through July of 2005, and 35%
hedged for the period of August 2005 through July of 2006.
Most of the gas distributed by UNS Gas in Arizona is procured from the San
Juan Basin in the Four Corners region and delivered on the El Paso and
Transwestern interstate pipeline systems. UNS Gas has firm transportation
agreements with El Paso Natural Gas (EPNG) and Transwestern Pipeline Company
(Transwestern) with combined capacity sufficient to meets its load requirements.
In July 2003, FERC required the conversion of UNS Gas' full requirements
status under the EPNG agreement to contract demand starting on September 1,
2003. UNS Gas now has specific volume limits in each month and specific receipt
point rights from the available supply basins (San Juan and Permian). The
average daily capacity rights of UNS Gas after conversion to contract demand is
approximately 870,000 therms per day, with an average of 1,200,000 therms per
day in the winter season (November through March). These changes have also
reduced the amount of less expensive San Juan gas available to UNS Gas. The
impact, however, is not expected to be material. The annual cost of the EPNG
capacity after conversion to contract demand did not change. These costs will be
the same through 2005 (pending a 2006 EPNG rate case after which the rates are
K-14
expected to increase) as under UNS Gas' existing full requirements contract.
This contract expires in August 2011.
UNS Gas has capacity rights of 250,000 therms per day on the San Juan
Lateral and Mainline of the Transwestern pipeline. The Transwestern pipeline
principally delivers gas to the portion of UNS Gas' distribution system serving
customers in Flagstaff and Kingman, Arizona, and also delivers gas to UNS Gas'
facilities serving the Griffith Power Plant in Mohave County. This contract
expires in January 2007.
The aggregate annual minimum transportation charges are expected to be
approximately $4 million and $3 million for the EPNG and Transwestern contracts,
respectively. These costs are passed through to our customers via the PGA
mechanism. See Rates and Regulation, below.
RATES AND REGULATION
UNS Gas is regulated by the ACC with respect to retail gas rates, the
issuance of securities, and transactions with affiliated parties. UNS Gas'
retail gas rates include a monthly customer charge, a base rate charge for
delivery services and the cost of gas (expressed in cents per therm), and a PGA
mechanism.
Purchased Gas Adjustor
----------------------
UNS Gas' retail rates include a PGA mechanism intended to address the
volatility of natural gas prices and allow UNS Gas to recover its costs through
a price adjuster. The difference between the actual cost of UNS Gas' gas
supplies and transportation contracts and the base cost of gas approved by the
ACC for recovery through base rates are deferred and recovered or repaid through
the PGA mechanism. The PGA charge changes monthly based on an ACC approved
mechanism that compares the twelve-month rolling average gas costs to the base
cost of gas, subject to limitations on how much the price per therm may change
in a twelve month period. When under or over recovery trigger points are meet,
UNS Gas may request a PGA surcharge or surcredit to collect or return the amount
deferred from or to customers.
ACC Order and Settlement Agreement
----------------------------------
The ACC order and settlement agreement approving the acquisition of the
Citizens gas and electric assets included the following terms related to UNS Gas
rates:
o An increase in retail delivery base rates, effective August 11, 2003,
equivalent to a 20.9% increase over 2001 test year retail revenues.
o Fair value rate base of $142 million and allowed rate of return of
7.49%, based on a cost of capital of 9.05%, derived from a cost of
equity of 11.00% and a cost of debt of 7.75% (based on a capital
structure of 40% equity and 60% debt).
o Change in rate design to include an increase in the monthly
residential customer charge from $5 to $7 and an increase in the base
cost of gas to $0.400 per therm from $0.250 in northern Arizona and
$0.3884 in Santa Cruz County.
o The then existing PGA rate change limit of $0.10 per therm over a
twelve-month period was increased to $0.15 through July 2004 and
thereafter reverted to $0.10.
On September 9, 2003, the ACC approved a new PGA surcharge of $0.1155 per
therm that took effect October 1, 2003 and ended November 1, 2004.
In January 2005, UNS Gas requested that the ACC approve a PGA surcharge of
$0.06 per therm beginning April 1, 2005 and remove it one year later, to recover
its excess gas purchase costs. On March 3, 2005, the ACC staff in its proposed
order, recommended the implementation of a $0.05 per therm surcharge beginning
April 1, 2005 to recover the uncollected PGA balance. At December 31, 2004, the
unrecovered PGA balance was $9 million.
Under the terms of the ACC order, UNS Gas may not file for a general rate
increase until August 2006 and any resulting rate increase may not become
effective until August 1, 2007. UNS Gas expects to file a general rate case in
August 2006. The settlement agreement also limits dividends payable by UNS Gas
to 75% of earnings until the ratio of common equity to total capitalization
reaches 40%. The ratio of common equity to total capitalization for UNS Gas at
December 31, 2004 was 37%.
K-15
On March 10, 2005, UniSource Energy made a $6 million equity investment in
UNS Gas which increased its ratio of common equity to total capitalization to
40%.
UNS ELECTRIC
------------
SERVICE TERRITORY AND CUSTOMERS
UNS Electric is an electric transmission and distribution company serving
approximately 85,000 retail customers in Mohave and Santa Cruz counties. These
counties had a population of approximately 222,000 in 2004.
UNS Electric's customer base is primarily residential, with some small
commercial and both light and heavy industrial customers. Peak demand for 2004
was 383 MW.
POWER SUPPLY AND TRANSMISSION
UNS Electric has a full requirements power supply agreement with Pinnacle
West Capital Corporation (PWCC). The agreement expires May 31, 2008. The
agreement obligates PWCC to supply all of UNS Electric's power requirements at a
fixed price. Payments under the contract are usage based, with no fixed customer
or demand charges. UNS Electric imports the power it purchases from PWCC into
its Mohave County and Santa Cruz County services territories over the Western
Area Power Administration's (WAPA) transmission lines. UNS Electric's
transmission capacity agreement with WAPA expires in February 2008. Under the
terms of the agreement, UNS Electric's aggregate minimum fixed transmission
charges are expected to be $5 million in 2005. UNS Electric also has a long-term
electric transmission capacity agreement with WAPA that expires in 2011. Under
the terms of this contract, the aggregate minimum transmission payments are $1
million per year.
UNS Electric owns and operates the Valencia Power Plant (Valencia), located
in Nogales, Arizona. The Valencia plant consists of three gas and diesel-fueled
combustion turbine units and provides approximately 48 MW of peaking resources.
The facility is directly interconnected with the distribution system serving the
city of Nogales and the surrounding areas. Under the PWCC agreement, Valencia
will be dispatched by PWCC when needed for local reliability or when it is
economic relative to other PWCC resources.
RATES AND REGULATION
UNS Electric is regulated by the ACC with respect to retail electric rates,
the issuance of securities, and transactions with affiliated parties, and by the
FERC with respect to wholesale power contracts and interstate transmission
service. UNS Electric's retail electric rates include a purchase power and fuel
adjustment clause (PPFAC), which allows for adjustment to the base rate for
delivered purchase power through a separate surcharge or credit.
The ACC order and settlement agreement approving the acquisition of the
Citizens gas and electric assets include the following terms related to UNS
Electric rates:
o A 22% increase in retail rates effective August 11, 2003 from the
rates previously in effect for Citizens. This reflects the
implementation of a PPFAC surcharge of $0.01825 per kWh, which
combined with the current base rate of $0.05194 per kWh, results in a
new delivered purchase power price of $0.07019 per kWh, to fully
recover the cost of the current contract with PWCC, WAPA transmission
charges and the cost of running the Valencia turbines.
o UNS Electric must attempt to renegotiate the PWCC purchase power
contract, and any savings that result from a renegotiated contract
must be allocated in a ratio of 90% to ratepayers and 10% to
shareholders. Discussions are underway relating to restructuring
options, however to date, no agreement had been reached.
Under the terms of the ACC order, UNS Electric may not file a general rate
increase until August 2006 and any resulting rate increase may not become
effective until August 1, 2007. UNS Electric expects to file a general rate case
in August 2006. The settlement agreement also limits dividends payable by UNS
Electric to 75% of earnings until the ratio of common equity to total
capitalization reaches 40%. The ratio of common equity to total capitalization
for UNS Electric at December 31, 2004 was 40%.
On March 10, 2005, UniSource Energy made a $4 million equity investment in
UNS Electric.
K-16
GLOBAL SOLAR ENERGY, INC.
-------------------------
Global Solar Energy, Inc. (Global Solar) develops and manufactures light
weight thin-film photovoltaic cells and panels. Global Solar's target markets
have included military, space and commercial applications. Millennium owns 99%
of Global Solar, and at December 31, 2004, Global Solar represented 1% of
UniSource Energy's total assets. To date, Millennium has been authorized to fund
up to an additional $5 million for capital expenditures and operations at Global
Solar.
OTHER
-----
OTHER MILLENNIUM INVESTMENTS
Through affiliates, Millennium holds investments in unregulated energy and
emerging technology companies. At December 31, 2004, Millennium's assets,
excluding Global Solar, represented 6% of UniSource Energy's total assets. It is
our intention for UniSource Energy to cease making capital contributions to
Millennium. See Item 7. - Management's Discussion and Analysis of Financial
Condition and Results of Operations, Millennium Energy Holdings, Inc., Results
of Operations, Millennium Commitments.
Millennium's other consolidated investments include:
Infinite Power Solutions, Inc. (IPS) develops thin-film lithium ion
batteries. Millennium owns 72% of IPS. To date, Millennium has been authorized
to fund up to $3 million for capital and operations at IPS.
Southwest Energy Solutions, Inc. (SES), a wholly-owned Millennium
subsidiary, provides electrical contracting services in Arizona to commercial,
industrial and governmental customers in both high voltage and inside wiring
capacities and meter reading services to TEP.
Millennium Environmental Group, Inc. (MEG), a wholly-owned Millennium
subsidiary established in September 2001, manages and trades emission
allowances, coal and other environmental related products including derivative
instruments. In accordance with UniSource Energy's intention to cease making
capital contributions to Millennium, Millennium has significantly reduced the
holdings and activity of MEG. MEG is in the process of winding down its
activities and does not anticipate engaging in any new activities after 2005.
Nations Energy Corporation (Nations Energy), a wholly-owned subsidiary of
Millennium, develops and invests in independent power projects worldwide.
Nations Energy has one remaining investment, a 32% equity interest in an
independent power producer that owns and operates a 43 MW power plant near
Panama City, Panama.
EQUITY METHOD MILLENNIUM INVESTMENTS
Millennium has the following equity method investments:
MicroSat Systems, Inc. (MicroSat) develops small-scale satellites under
U.S. government contracts. Millennium owns 35% of MicroSat.
Haddington Energy Partners II, LP (Haddington) is a limited partnership
that funds energy-related investments. A member of the UniSource Energy Board of
Directors has an investment in Haddington and is a managing director of the
general partner of the limited partnership. Millennium committed $15 million in
capital, excluding fees, to Haddington in exchange for approximately 31%
ownership. At December 31, 2004, Millennium had $4 million remaining on this
commitment, which is expected to be funded over the next two years.
Valley Ventures III, LP (Valley Ventures) is a venture capital fund that
focuses on investments in information technology, microelectronics and
biotechnology, primarily within the southwestern U.S. Another member of the
UniSource Energy Board of Directors is a general partner of the company that
manages the fund. Millenium committed $6 million, including fees, to the fund
and owns approximately 15% of the fund. At December 31, 2004, Millennium had $3
million remaining on this commitment, which is expected to be funded over the
next four years.
Carboelectrica Sabinas, S. de R.L. de C.V. (Sabinas) is a Mexican limited
liability company created to develop up to 800 MW of coal-fired generation in
the Sabinas region of Coahuila, Mexico. Sabinas also owns 19.5% of Minerales de
Monclova, S.A. de C.V. (Mimosa). Mimosa is an owner of coal and associated gas
K-17
reserves and a supplier of metallurgical coal to the Mexican steel industry and
thermal coal to the major electric utility in Mexico. Millennium owns 50% of
Sabinas. Altos Hornos de Mexico, S.A. de C.V. (AHMSA) and affiliates also own
50%. Also, UniSource Energy's Chairman, President and Chief Executive Officer is
a member of the Board of Directors of AHMSA. Since 1999, both AHMSA and Mimosa
are parties to a suspension of payments procedure, under applicable Mexican law,
which is the equivalent of a U.S. Chapter 11 proceeding. Under certain
circumstances, Millennium has the right to sell (a put option) its interest in
Sabinas to an AHMSA affiliate for $20 million plus an accrued service fee. These
circumstances include failure of Sabinas to reach financial closing on the
generation project within a specified time. Millennium's put option is secured
by collateral currently valued in excess of $20 million. In 2003, Millennium
received $1 million of returned capital from the investment. At December 31,
2004, the book value of the investment in Sabinas was approximately $19 million.
As technology developers, IPS and MicroSat face many challenges, such as
developing technologies that can be manufactured on an economic scale,
technological obsolescence, competitors and possible reductions in government
spending to advance technological research and development activities. See Item
7. - Management's Discussion and Analysis of Financial Condition and Results of
Operations, Other, Results of Operations for more information regarding
Millennium's unregulated energy businesses and other investments, including
research and development activities.
UNISOURCE ENERGY DEVELOPMENT COMPANY
In October 2003, UED, TEP, Tri-State and SRP entered into a joint
development agreement, which provides for the development of two 400 MW
coal-fired units at TEP's existing Springerville Generating Station by parties
other than TEP. Based on this Agreement, TEP transferred the right to construct
Unit 3, together with associated rights, to Tri-State.
Springerville was originally designed for four units. Springerville Unit 3,
and, if constructed, Unit 4, will each consist of a 400 MW coal-fired, base-load
generating facility at the same site as Springerville Units 1 and 2. When Unit 3
(and possibly Unit 4) is built, TEP would spread the fixed costs of the existing
common facilities over the additional generating unit (or units).
In October 2003, Tri-State completed financing of Unit 3 and immediately
began construction. UED received reimbursement of its development costs totaling
$29 million, and an $11 million development fee.
Once built, Tri-State will lease 100% of Unit 3 from a financial owner and
take 300 MW of the 400 MW capacity. TEP will operate Unit 3 and will purchase up
to 100 MW of Tri-State system capacity for no more than five years from the time
the plant begins commercial operation. UED expects commercial operation of Unit
3 to occur in the third quarter of 2006. SRP will purchase 100 MW of capacity
from Unit 3 under a 30 year power purchase agreement and will have the right to
construct and own Unit 4 at a later date. If SRP decides to construct Unit 4,
TEP may be required, along with Tri-State, to exercise best efforts to find a
replacement purchaser for SRP to purchase 100 MW of capacity from Unit 3. If TEP
and Tri-State are unable to find such a replacement purchaser, TEP would then
purchase 100 MW of output from Unit 4, beginning with the commercial operation
of Unit 4. Under the terms of the existing EPA permit, Unit 4 is required to be
completed by December 31, 2009.
Upon the completion of construction, TEP expects to receive annual pre-tax
benefits of approximately $15 million in the form of cost savings, rental
payments, transmission revenues, and other fees. TEP will also benefit from
upgraded emissions controls for Units 1 and 2, totaling approximately $90
million, which will be paid for by the Unit 3 project.
EMPLOYEES (AS OF DECEMBER 31, 2004)
-----------------------------------
TEP had 1,208 employees, of which approximately 56% are represented by the
International Brotherhood of Electrical Workers (IBEW) Local No. 1116. A
three-year collective bargaining agreement between the IBEW and TEP was ratified
in December 2002 and extends through 2005. Wages for bargaining unit employees
increased 3% effective January 3, 2005. Wage increases for 2005 and 2006 will be
determined annually during July and August of each preceding year.
UNS Gas had 195 employees, of which 108 employees were represented by IBEW
Local No. 1116 and 6 employees were represented by IBEW Local No. 387. The
agreements with the IBEW Local 1116 and No. 387 expire in June 2009 and February
2010, respectively.
K-18
UNS Electric had 155 employees, of which 30 employees were represented by
the IBEW Local No. 387 and 99 employees were represented by the IBEW Local No.
769. The existing agreement with the IBEW Local No. 387 expires in February 2010
and the agreement with IBEW Local No. 769 expires in July 2007.
Global Solar had 82 employees.
Millennium and its other wholly-owned subsidiaries, which include SES and
MEG, had 190 employees. SES had 184 employees, of which approximately 95% are
represented by unions. Of the employees represented by unions, 76% are
represented by IBEW Local No. 1116, 15% by IBEW Local 769, 8% by IBEW Local No.
570 and 1% by IBEW Local No. 387. The existing agreements expire as follows:
IBEW Local No. 1116, October 2006; IBEW Local No. 769, July 2007; IBEW Local No.
570, May 2006; and IBEW Local No. 387, February 2010.
SEC REPORTS AVAILABLE ON UNISOURCE ENERGY'S WEBSITE
---------------------------------------------------
UniSource Energy and TEP make available their annual reports on Form 10-K,
quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments
to those reports as soon as reasonably practicable after they electronically
file them with, or furnish them to, the SEC. These reports are available free of
charge through UniSource Energy's website address:
http://www.unisourceenergy.com. A link from UniSource Energy's website to these
SEC reports is accessible as follows: At the UniSource Energy main page, select
Investor Relations from the menu shown at the top of the page; next select SEC
filings from the menu shown on the Investor Relations page.
Information contained at UniSource Energy's website is not part of any
report filed with the SEC by UniSource Energy or TEP.
The SEC also maintains an Internet site that contains reports, proxy and
information statements, and other information regarding issuers that file
electronically with the SEC. The SEC website address is http://www.sec.gov.
Interested parties may also read and copy any materials UniSource Energy or TEP
file with the SEC at the SEC's Public Reference Room at 450 Fifth Street, NW,
Washington, DC 20549. Information on the operation of the Public Reference Room
is available by calling the SEC at 1-800-SEC-0030.
ITEM 2. - PROPERTIES
--------------------------------------------------------------------------------
TEP PROPERTIES
--------------
TEP's transmission facilities, located in Arizona and New Mexico, transmit
electricity from TEP's remote electric generating stations at Four Corners,
Navajo, San Juan and Springerville to the Tucson area for use by TEP's retail
customers (see Item 1. - Business - Generating and Other Resources). The
transmission system is interconnected at various points in Arizona and New
Mexico with a number of regional utilities. TEP has arrangements with
approximately 120 companies to interchange generation capacity and transmission
of energy.
As of December 31, 2004, TEP owned, or participated in, an overhead
electric transmission and distribution system consisting of:
o 512 circuit-miles of 500-kV lines;
o 1,122 circuit-miles of 345-kV lines;
o 371 circuit-miles of 138-kV lines;
o 434 circuit-miles of 46-kV lines; and
o 3,362 circuit-miles of lower voltage primary lines.
The underground electric distribution system is comprised of 4,150
cable-miles. TEP owns approximately 77% of the poles on which the lower voltage
lines are located. Electric substation capacity consisted of 198 substations
with a total installed transformer capacity of 6,018,772 kilovolt amperes.
The electric generating stations (except as noted below), operating
headquarters, warehouse and service center are located on land owned by TEP. The
electric distribution and transmission facilities owned by TEP are located:
o on property owned by TEP;
K-19
o under or over streets, alleys, highways and other public places, the
public domain and national forests and state lands under franchises,
easements or other rights which are generally subject to termination;
o under or over private property as a result of easements obtained
primarily from the record holder of title; or
o over American Indian reservations under grant of easement by the
Secretary of Interior or lease by American Indian tribes.
It is possible that some of the easements, and the property over which the
easements were granted, may have title defects or may be subject to mortgages or
liens existing at the time the easements were acquired.
Springerville is located on land parcels held by TEP under a long-term
surface ownership agreement with the State of Arizona.
Four Corners and Navajo are located on properties held under easements from
the United States and under leases from the Navajo Nation. TEP, individually and
in conjunction with PNM in connection with San Juan, has acquired easements and
leases for transmission lines and a water diversion facility located on land
owned by the Navajo Nation. TEP has also acquired easements for transmission
facilities, related to San Juan, Four Corners, and Navajo, across the Zuni,
Navajo and Tohono O'odham Indian Reservations.
TEP's rights under these various easements and leases may be subject to
defects such as:
o possible conflicting grants or encumbrances due to the absence of or
inadequacies in the recording laws or record systems of the Bureau of
Indian Affairs and the American Indian tribes;
o possible inability of TEP to legally enforce its rights against
adverse claimants and the American Indian tribes without Congressional
consent; or
o failure or inability of the American Indian tribes to protect TEP's
interests in the easements and leases from disruption by the U.S.
Congress, Secretary of the Interior, or other adverse claimants.
These possible defects have not interfered and are not expected to
materially interfere with TEP's interest in and operation of its facilities.
TEP, under separate sale and leaseback arrangements, leases the following
generation facilities (which do not include land):
o coal handling facilities at Springerville;
o a 50% undivided interest in the Springerville Common Facilities;
o Springerville Unit 1 and the remaining 50% undivided interest in the
Springerville Common Facilities; and
o Sundt Unit 4 and related common facilities.
See Note 10 of Notes to Consolidated Financial Statements, and Item 7. -
Management's Discussion and Analysis of Financial Condition and Results of
Operations, Tucson Electric Power Company, Liquidity and Capital Resources,
Contractual Obligations, for additional information on TEP's capital lease
obligations.
Substantially all of the utility assets owned by TEP are subject to the
lien of the General First Mortgage and the General Second Mortgage.
Springerville Unit 2, which is owned by San Carlos, is not subject to those
liens.
UES PROPERTIES
--------------
UNS GAS
As of December 31, 2004, UNS Gas' transmission and distribution system
consisted of approximately 78 miles of steel transmission mains, 3,399 miles of
steel and plastic distribution mains, and 137,874 customer service lines.
UNS ELECTRIC
As of December 31, 2004, UNS Electric's transmission and distribution
system consisted of approximately 56 circuit-miles of 115-kV transmission lines,
K-20
224 circuit-miles of 69-kV transmission lines, and 3,189 circuit-miles of
underground and overhead distribution lines. UNS Electric also owns 38
substations having a total installed capacity of 1,131,300 kilovolt amperes and
the 48 MW Valencia plant.
The gas and electric distribution and transmission facilities owned by UNS
Gas and UNS Electric are located:
o on property owned by UNS Gas or UNS Electric;
o under or over streets, alleys, highways and other public places, the
public domain and national forests and state lands under franchises,
easements or other rights which are generally subject to termination;
or
o under or over private property as a result of easements obtained
primarily from the record holder of title.
It is possible that some of the easements, and the property over which the
easements were granted, may have title defects or may be subject to mortgages or
liens existing at the time the easements were acquired.
GLOBAL SOLAR PROPERTIES
-----------------------
Global Solar leases its manufacturing facilities from Millennium. The
manufacturing facility is located in Tucson, Arizona and is approximately 31,000
square feet.
ITEM 3 - LEGAL PROCEEDINGS
--------------------------------------------------------------------------------
See Item 7. - Management's Discussion and Analysis of Financial Condition
and Results of Operations, Tucson Electric Power Company, Factors Affecting
Operations, for litigation related to ACC orders and retail competition.
We discuss other legal proceedings in Note 8 of Notes to Consolidated
Financial Statements.
CROSS-COMPLAINTS IN WHOLESALE ELECTRICITY ANTITRUST CASES I AND II
In late 2000, various California municipalities and citizens filed suits
against Duke Energy Trading and Marketing, L.L.C., Reliant Energy Services, Inc.
and other large suppliers of wholesale electricity alleging that Duke, Reliant,
and the other large suppliers violated antitrust laws by colluding to effect the
price of electricity in the California wholesale electricity market. These
actions were subsequently consolidated in San Diego Superior Court in March 2002
as Wholesale Electricity Antitrust Cases I and II.
Duke and Reliant responded by filing cross-complaints against TEP and
numerous other wholesale electricity market participants in April 2002. The
cross complaints allege that cross-defendants sold power in significant amounts
at prices the antitrust plaintiffs allege were excessive, and as participants in
power sales, cross-defendants are equally liable for plaintiffs alleged damages.
The entire action was removed to the United States District Court for the
Southern District of California in May 2002. The antitrust plaintiffs responded
to the removal by filing a motion for remand, and on December 13, 2002, the
District Court remanded the case back to state court.
Duke and Reliant appealed the District Court's remand order and requested
that the order be stayed pending resolution of their appeal. On December 8,
2004, the Ninth Circuit affirmed the District Court's remand. Once the mandate
issues and the case is actually transferred, TEP and other defendants will then
file a motion to dismiss the cross-complaint.
TEP believes these claims are without merit and intends to vigorously
contest them.
CITY OF TACOMA
On June 7, 2004, the City of Tacoma, Washington filed a lawsuit (City of
Tacoma v. American Electric Power Services Corporation, et al. (U.S. District
Ct. W. D. Wash.)) against TEP and various other electricity generators and
marketers alleging that the defendants violated antitrust laws by colluding to
effect the price of electricity in the Pacific Northwest from May 2000 through
2001. These claims are similar to those alleged in the antitrust cases against
TEP and other wholesale electricity market participants described above in
Cross-Complaints in Wholesale Electricity Antitrust Cases I and II. Accordingly,
on September 14, 2004, the case was transferred to the United States District
K-21
Court for the Southern District of California and consolidated with the
Wholesale Electricity Antitrust Cases I and II. TEP along with other defendants
have filed a motion to dismiss the City of Tacoma complaint.
TEP believes these claims are without merit and intends to vigorously
contest them.
CALIFORNIA ATTORNEY GENERAL'S UNFAIR COMPETITION LAWSUITS
Beginning in April 2002, the California Attorney General filed complaints
against TEP and other wholesale electricity suppliers or marketers in San
Francisco Superior Court. The complaints seek to impose civil penalties under
California's unfair competition law based upon allegations that defendants
violated the Federal Power Act by failing to properly file their rates with FERC
and by charging "unjust and unreasonable" rates.
Defendants removed the cases to the United States District Court for the
Northern District of California where they were consolidated. The District Court
then dismissed the California Attorney General's complaints finding them barred
by federal preemption and the filed rate doctrine. The California Attorney
General appealed the District Court's dismissal of the complaints. On October
12, 2004, the Ninth Circuit Court of Appeals issued a memorandum decision
affirming the dismissal and that decision is now final.
ITEM 4. - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
--------------------------------------------------------------------------------
Not applicable.
PART II
ITEM 5. - MARKET FOR REGISTRANT'S COMMON EQUITY RELATED STOCKHOLDER MATTERS AND
ISSUER PURCHASES OF COMMON EQUITY
--------------------------------------------------------------------------------
STOCK TRADING
UniSource Energy's Common Stock is traded under the ticker symbol UNS. It
is listed on the New York Stock Exchange and the Pacific Exchange. On March 11,
2005, the closing price was $30.54, with 13,196 shareholders of record.
UniSource Energy did not purchase any shares of its common stock during the
fourth quarter of 2004.
DIVIDENDS
UniSource Energy's Board of Directors currently expects to continue to pay
regular quarterly cash dividends on our common stock subject, however, to the
directors' evaluation of our financial condition, earnings, cash flows and
dividend policy. On February 4, 2005, UniSource Energy's Board of Directors
indicated its desire to target, over the next several years, a dividend payout
level of up to 50 percent of net income.
TEP pays dividends on its common stock after its Board of Directors
declares them. UniSource Energy is the primary shareholder of TEP's common
stock. UniSource Energy relies on dividends from its subsidiaries, primarily
TEP, to declare and pay dividends to its shareholders. See Note 12 of Notes to
Consolidated Financial Statements for a discussion of limitations on UniSource
Energy's subsidiaries ability to pay dividends to UniSource Energy.
See Item 7. - Management's Discussion and Analysis of Financial Condition
and Results of Operations, UniSource Energy Consolidated, Dividends on Common
Stock.
COMMON STOCK DIVIDENDS AND PRICE RANGES
---------------------------------------------------------------------------
2004 2003
Quarter: Market Price per Dividends Market Price per Dividends
Share of Common Declared Share of Common Declared
Stock (1) Stock (1)
High Low High Low
---- --- ---- ---
K-22
First $24.74 $ 24.11 $0.16 $18.10 $ 16.00 $0.15
Second 24.93 24.15 0.16 19.27 17.05 0.15
Third 24.94 24.20 0.16 19.80 17.65 0.15
Fourth 24.88 22.90 0.16 24.90 19.01 0.15
---------------------------------------------------------------------------
Total $0.64 $0.60
===========================================================================
(1) UniSource Energy's Common Stock price as reported in the consolidated
reporting system.
On February 4, 2005, UniSource Energy declared a cash dividend of $0.19 per
share on its Common Stock. The dividend was paid March 8, 2005 to shareholders
of record at the close of business February 15, 2005.
TEP declared and paid cash dividends of $32 million in 2004, $80 million in
2003, and $35 million in 2002.
CONVERTIBLE SENIOR NOTES
On March 1, 2005, UniSource Energy issued $150 million aggregate principal
amount of 4.50% Convertible Senior Notes due 2035 through a domestic offering to
qualified institutional buyers pursuant to Rule 144A under the Securities Act of
1933 (the Act) and to non-U.S. persons in offshore transactions in reliance on
Regulation S under the Act. See Item 7. - Management's Discussion and Analysis
of Financial Condition and Results of Operations, UniSource Energy Consolidated,
Liquidity and Capital Resources, Financing Activities.
ITEM 6. - SELECTED CONSOLIDATED FINANCIAL DATA
--------------------------------------------------------------------------------
UNISOURCE ENERGY 2004 2003 2002 2001 2000
------------------------------------------------------------------------------------------------------------------------------
- In Thousands -
(except per share data)
SUMMARY OF OPERATIONS
------------------------------------------------------------------------------------------------------------------------------
Operating Revenues (1) $1,168,978 $ 972,755 $ 839,576 $ 1,613,304 $ 1,036,630
Loss Before Income Taxes of Millennium $ (6,920) $ (26,350) $ (30,702) $ (14,455) $ (12,059)
Energy Businesses
Income Before Extraordinary Item and $ 45,919 $ 46,470 $ 34,928 $ 63,369 $ 43,484
Accounting Change (1)
Net Income (1) (2) $ 45,919 $ 113,941 $ 34,928 $ 63,839 $ 43,484
Basic Earnings per Share:
Before Extraordinary Item & Accounting
Change $ 1.34 $ 1.38 $ 1.04 $ 1.90 $ 1.34
Net Income $ 1.34 $ 3.37 $ 1.04 $ 1.91 $ 1.34
Diluted Earnings per Share:
Before Extraordinary Item & Accounting
Change $ 1.31 $ 1.35 $ 1.02 $ 1.86 $ 1.32
Net Income $ 1.31 $ 3.32 $ 1.02 $ 1.87 $ 1.32
Shares of Common Stock Outstanding
Average 34,380 33,828 33,665 33,398 32,445
End of Year 34,255 33,788 33,579 33,502 33,219
Year-end Book Value per Share $16.95 $16.47 $13.60 $13.17 $11.60
Cash Dividends Declared per Share $ 0.64 $ 0.60 $ 0.50 $ 0.40 $ 0.24
------------------------------------------------------------------------------------------------------------------------------
FINANCIAL POSITION
------------------------------------------------------------------------------------------------------------------------------
Total Utility Plant - Net $2,081,137 $ 2,069,215 $ 1,835,904 $ 1,832,164 $ 1,848,975
Investments in Lease Debt and Equity $ 170,893 $ 178,789 $ 191,867 $ 84,459 $ 71,639
Other Investments and Other Property $ 85,035 $ 109,570 $ 123,238 $ 98,288 $ 50,172
Total Assets $3,175,518 $ 3,122,719 $ 2,885,954 $ 2,925,937 $ 2,834,289
Long-Term Debt (3) $1,257,595 $ 1,286,320 $ 1,128,963 $ 802,804 $ 1,132,395
Non-Current Capital Lease Obligations 701,931 762,968 801,611 853,793 857,829
K-23
Common Stock Equity 580,718 556,472 456,640 441,133 385,483
------------------------------------------------------------------------------------------------------------------------------
Total Capitalization $2,540,244 $ 2,605,760 $ 2,387,214 $ 2,097,730 $ 2,375,707
------------------------------------------------------------------------------------------------------------------------------
SELECTED CASH FLOW DATA
------------------------------------------------------------------------------------------------------------------------------
Net Cash Flows From Operating Activities $ 306,979 $ 263,396 $ 176,437 $ 215,379 $ 215,034
Capital Expenditures $ (167,017) $ (137,282) $ (112,706) $ (121,735) $ (105,996)
Other Investing Cash Flows 10,828 (213,450) (158,184) 4,888 (7,554)
------------------------------------------------------------------------------------------------------------------------------
Net Cash Flows From Investing Activities $ (156,189) $ (350,732) $ (270,890) $ (116,847) $ (113,550)
------------------------------------------------------------------------------------------------------------------------------
Net Cash Flows From Financing Activities $ (98,028) $ 97,674 $ (42,773) $ (33,382) $ (83,768)
------------------------------------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------------------------------------
Ratio of Earnings to Fixed Charges (4) 1.43 1.37 1.36 1.77 1.37
------------------------------------------------------------------------------------------------------------------------------
(1) In 2003, Operating Revenues, Income Before Extraordinary Item and Accounting
Change and Net Income include results from UES for the period from August 11,
2003 to December 31, 2003.
(2) Net income includes an after-tax gain of $67 million for the Cumulative
Effect of Accounting Change from the adoption of FAS 143 in 2003 and $0.5
million for the Cumulative Effect of Accounting Change from the Adoption of FAS
133 in 2001.
(3) TEP's tax-exempt variable rate bonds in the amount of $329 million are
backed by LOCs issued under TEP's Credit Agreement. TEP's obligations under the
Credit Agreement are collateralized with Second Mortgage Bonds. In November
2002, TEP obtained new LOCs in the amount of $341 million to replace the LOCs
provided under its then existing Credit Agreement that would have expired on
December 30, 2002. The 2002 LOCs would have expired in 2006. Accordingly, these
IDBs were classified as short-term debt at December 31, 2001 and classified as
long-term debt at December 31, 2002. TEP entered into a new Credit Agreement in
March 2004, which provided LOCs that expire in 2009.
(4) For purposes of this computation, earnings are defined as pretax earnings
from continuing operations before minority interest, plus interest expense, and
amortization of debt discount and expense related to indebtedness. Fixed charges
are interest expense, including amortization of debt discount and expense on
indebtedness.
See Item 7. - Management's Discussion and Analysis of Financial Condition and
Results of Operations.
ITEM 6. - SELECTED CONSOLIDATED FINANCIAL DATA
--------------------------------------------------------------------------------
TEP 2004 2003 2002 2001 2000
-------------------------------------------------------------------------------
- Thousands of Dollars -
SUMMARY OF OPERATIONS
------------------------------------------------------------------------------------------------------------------------------
Operating Revenues $ 889,298 $ 851,551 $ 834,447 $ 1,604,961 $ 1,031,329
Income Before Extraordinary Item and $ 46,127 $ 61,442 $ 55,390 $ 77,308 $ 52,762
Accounting Change
Net Income (1) $ 46,127 $ 128,913 $ 55,390 $ 77,778 $ 52,762
------------------------------------------------------------------------------------------------------------------------------
FINANCIAL POSITION
------------------------------------------------------------------------------------------------------------------------------
Total Utility Plant - Net $ 1,816,782 $ 1,832,156 $ 1,835,904 $ 1,832,164 $ 1,848,975
Investments in Lease Debt and Equity $ 170,893 $ 178,789 $ 191,867 $ 84,459 $ 69,474
Other Investments and Other Property $ 23,393 $ 41,285 $ 21,358 $ 21,416 $ 22,860
Total Assets $ 2,742,168 $ 2,767,047 $ 2,808,810 $ 2,824,555 $ 2,763,840
Long-Term Debt(2) $ 1,097,595 $ 1,126,320 $ 1,128,410 $ 801,924 $ 1,132,395
Non-Current Capital Lease Obligations 701,405 762,323 801,508 853,447 857,519
Common Stock Equity 414,510 406,054 353,832 337,082 307,596
------------------------------------------------------------------------------------------------------------------------------
Total Capitalization $ 2,213,510 $ 2,294,697 $ 2,283,750 $ 1,992,453 $ 2,297,510
------------------------------------------------------------------------------------------------------------------------------
K-24
SELECTED CASH FLOW DATA
-------------------------------------------------------------------------------------------------------------------------------
Net Cash Flows From Operating Activities $ 275,151 $ 260,989 $ 206,991 $ 261,169 $ 234,190
Capital Expenditures $ (129,505) $ (121,854) $ (103,307) $ (103,913) $ (98,063)
Other Investing Cash Flows 3,743 11,408 (151,035) (8,861) (23,273)
-------------------------------------------------------------------------------------------------------------------------------
Net Cash Flows From Investing Activities $ (125,762) $ (110,446) $ (254,342) $ (112,774) $ (121,336)
-------------------------------------------------------------------------------------------------------------------------------
Net Cash Flows From Financing Activities $ (101,444) $ (141,059) $ (56,551) $ (77,427) $ (112,544)
-------------------------------------------------------------------------------------------------------------------------------
RATIO OF EARNINGS TO FIXED CHARGES (3) 1.51 1.51 1.60 1.85 1.49
-------------------------------------------------------------------------------------------------------------------------------
(1) Net Income includes an after-tax gain of $67 million for the Cumulative
Effect of Accounting change from the Adoption of FAS 143 in 2003 and $0.5
million for the Cumulative Effect of Accounting Change from the Adoption of FAS
133 in 2001.
(2) TEP's tax-exempt variable rate bonds in the amount of $329 million are
backed by LOCs issued under TEP's Credit Agreement. TEP's obligations under the
Credit Agreement are collateralized with Second Mortgage Bonds. In November
2002, TEP obtained new LOCs in the amount of $341 million to replace the LOCs
provided under its then existing Credit Agreement that would have expired on
December 30, 2002. The 2002 LOCs would have expired in 2006. Accordingly, these
IDBs were classified as short-term debt at December 31, 2001 and classified as
long-term debt at December 31, 2002. TEP entered into a new Credit Agreement in
March 2004, which provided LOCs that expire in 2009.
(3) For purposes of this computation, earnings are defined as pre-tax earnings
from continuing operations before minority interest, plus interest expense and
amortization of debt discount and expense related to indebtedness. Fixed charges
are interest expense, including amortization of debt discount and expense on
indebtedness.
Note: Disclosure of earnings per share information for TEP is not presented as
the common stock of TEP is not publicly traded.
See Item 7. - Management's Discussion and Analysis of Financial Condition
and Results of Operations.
NON-GAAP MEASURES
ADJUSTED EBITDA
---------------
Adjusted EBITDA represents EBITDA excluding the cumulative effect of
accounting change which is a non-cash item. EBITDA is earnings before interest,
taxes, depreciation and amortization. Adjusted EBITDA is presented here as a
measure of liquidity because it can be used as an indication of a company's
ability to incur and service debt and is commonly used as an analytical
indicator in our industry. Adjusted EBITDA measures presented may not be
comparable to similarly titled measures used by other companies. Adjusted EBITDA
is not a measurement presented in accordance with United States generally
accepted accounting principles (GAAP), and we do not intend Adjusted EBITDA to
represent cash flows from operations as defined by GAAP. Adjusted EBITDA should
not be considered to be an alternative to cash flows from operations or any
other items calculated in accordance with GAAP or an indicator of our operating
performance.
UniSource Energy and TEP view Adjusted EBITDA, a non-GAAP financial
measure, as a liquidity measure. The most directly comparable GAAP measure to
Adjusted EBITDA is Net Cash Flows from Operating Activities.
ADJUSTED EBITDA AND NET CASH FLOWS FROM OPERATING ACTIVITIES
UNISOURCE ENERGY 2004 2003 2002 2001
--------------------------------------------------------------------------------
- Millions of Dollars -
Adjusted EBITDA $ 439 $ 395 $ 366 $ 419
Net Cash Flows from Operating
Activities $ 307 $ 263 $ 176 $ 215
--------------------------------------------------------------------------------
TEP 2004 2003 2002 2001
--------------------------------------------------------------------------------
- Millions of Dollars -
Adjusted EBITDA $ 411 $ 403 $ 399 $ 439
Net Cash Flows from Operating
Activities $ 275 $ 261 $ 207 $ 261
--------------------------------------------------------------------------------
K-25
RECONCILIATION OF ADJUSTED EBITDA TO CASH FLOWS FROM OPERATIONS
UNISOURCE ENERGY 2004 2003 2002 2001
--------------------------------------------------------------------------------
- Millions of Dollars -
ADJUSTED EBITDA (1) $ 439 $ 395 $ 366 $ 419
Amounts from the Income Statements:
Less: Income Taxes (34) (12) (18) (49)
Less: Total Interest Expense (168) (167) (155) (159)
Changes in Assets and Liabilities
and Other Non-Cash Items 70 47 (17) 4
--------------------------------------------------------------------------------
NET CASH FLOWS FROM OPERATING
ACTIVITIES $ 307 $ 263 $ 176 $ 215
================================================================================
TEP 2004 2003 2002 2001
--------------------------------------------------------------------------------
- Millions of Dollars -
ADJUSTED EBITDA (1) $ 411 $ 403 $ 399 $ 439
Amounts from the Income Statements:
Less: Income Taxes (35) (21) (36) (58)
Less: Total Interest Expense (157) (161) (154) (158)
Changes in Assets and Liabilities
and Other Non-Cash Items 56 40 (2) 38
--------------------------------------------------------------------------------
NET CASH FLOWS FROM OPERATING
ACTIVITIES $ 275 $ 261 $ 207 $ 261
================================================================================
(1) ADJUSTED EBITDA WAS CALCULATED AS FOLLOWS:
UNISOURCE ENERGY 2004 2003 2002 2001
---------------------------------------------------------------------------
- Millions of Dollars -
NET INCOME $ 46 $ 114 $ 35 $ 63
Amounts from the Income
Statements:
Less: Cumulative Effect of
Accounting Change - (67) - (1)
Plus: Income Taxes 34 12 18 49
Plus: Total Interest Expense 168 167 155 159
Plus: Depreciation and
Amortization 135 131 128 120
Plus: Amortization of
Transition
Recovery Asset 50 32 24 23
Plus: Depreciation included
in Fuel and Other O&M
Expense (see Note 20 of
Notes to Consolidated
Financial Statements) 6 6 6 6
---------------------------------------------------------------------------
ADJUSTED EBITDA $439 $ 395 $ 366 $ 419
===========================================================================
TEP 2004 2003 2002 2001
---------------------------------------------------------------------------
- Millions of Dollars -
NET INCOME $ 46 $ 129 $ 55 $ 78
Amounts from the Income
Statements:
Less: Cumulative Effect of
Accounting Change - (67) - (1)
Plus: Income Taxes 35 21 36 58
Plus: Total Interest Expense 157 161 154 158
Plus: Depreciation and
Amortization 117 121 124 117
Plus: Amortization of
Transition Recovery
Asset 50 32 24 23
Plus: Depreciation included in
Fuel and Other O&M
Expense (see Note 20
of Notes to Consolidated
Financial Statements) 6 6 6 6
---------------------------------------------------------------------------
ADJUSTED EBITDA $411 $ 403 $ 399 $ 439
===========================================================================
NET DEBT AND TOTAL DEBT AND CAPITAL LEASE OBLIGATIONS - TEP
-----------------------------------------------------------
Net Debt represents the current and non-current portions of TEP's long-term
debt and capital lease obligations less investment in lease debt. We have
subtracted investment in lease debt because it represents TEP's ownership of the
debt component of its own capital lease obligations. Net Debt measures presented
may not be comparable to similarly titled measures used by other companies. Net
Debt is not a measurement presented in accordance with GAAP and we do not intend
K-26
Net Debt to represent debt as defined by GAAP. You should not consider Net Debt
to be an alternative to debt or any other items calculated in accordance with
GAAP.
AS OF DECEMBER 31, 2004 2003 2002 2001
--------------------------------------------------------------------------------
- Millions of Dollars -
Net Debt $1,684 $1,761 $1,783 $1,921
Total Debt and Capital Lease
Obligations $1,855 $1,940 $1,975 $2,005
--------------------------------------------------------------------------------
RECONCILIATION OF TOTAL DEBT AND CAPITAL LEASE OBLIGATIONS TO NET DEBT
AS OF DECEMBER 31, 2004 2003 2002 2001
--------------------------------------------------------------------------------
- Millions of Dollars -
Long-Term Debt $1,098 $1,126 $1,128 $ 802
Current Portion - Long-Term Debt 2 2 2 330
--------------------------------------------------------------------------------
TOTAL DEBT 1,100 1,128 1,130 1,132
--------------------------------------------------------------------------------
Capital Lease Obligations 701 762 802 853
Current Portion - Capital Lease
Obligations 54 50 43 20
--------------------------------------------------------------------------------
TOTAL DEBT AND CAPITAL LEASE
OBLIGATIONS 1,855 1,940 1,975 2,005
--------------------------------------------------------------------------------
Investment in Lease Debt (171) (179) (192) (84)
--------------------------------------------------------------------------------
NET DEBT $1,684 $1,761 $1,783 $1,921
================================================================================
ITEM 7. - MANAGEMENT'S DISCUSSI0N AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
--------------------------------------------------------------------------------
Management's Discussion and Analysis explains the results of operations,
the general financial condition, and the outlook for UniSource Energy and its
four primary business segments and includes the following:
o outlook and strategies,
o operating results during 2004 compared with 2003, and 2003 compared
with 2002,
o factors which affect our results and outlook,
o liquidity, capital needs, capital resources, and contractual
obligations,
o dividends, and
o critical accounting estimates.
UniSource Energy is a holding company that has no significant operations of
its own. Operations are conducted by UniSource Energy's subsidiaries, each of
which is a separate legal entity with its own assets and liabilities. UniSource
Energy owns substantially all of the outstanding common stock of TEP, and all of
the outstanding common stock of UniSource Energy Services, Inc. (UES),
Millennium Energy Holdings, Inc. (Millennium), and UniSource Energy Development
Company (UED).
TEP, an electric utility, has provided electric service to the community of
Tucson, Arizona, for over 100 years. UES began operations in August 2003. UES,
through its two operating subsidiaries, UNS Gas and UNS Electric, provides gas
and electric service to 30 communities in northern and southern Arizona.
Millennium invests in unregulated businesses, including Global Solar Energy
(Global Solar) a developer and manufacturer of thin-film photovoltaic cells and
modules. UED engages in developing generating resources and other project
development activities, including facilitating the expansion of the
Springerville Generating Station. We conduct our business in these four primary
business segments - TEP's Electric Utility Segment, UNS Gas, UNS Electric and
Global Solar.
TEP is the principal operating subsidiary of UniSource Energy and, at
December 31, 2004, represented approximately 84% of its assets. The seasonal
nature of TEP's business causes operating results to vary significantly from
quarter to quarter. UniSource Energy's results for 2004 include four full
quarters of operations of UNS Gas and UNS Electric. UNS Gas and UNS Electric
were not in operation during the first seven months and eleven days of 2003.
Although representing approximately 1% of UniSource Energy's total assets,
losses from Global Solar had a significant impact on earnings reported by
UniSource Energy in 2004 and 2003. Results of operations from UniSource Energy's
Other segment consist of the income and losses associated with Millennium's
other investments, excluding Global Solar; results of operations at UED, which
was established in February 2001 to oversee the development of Springerville
K-27
Unit 3; inter-company transactions; and UniSource Energy parent company
expenses. UED had a significant impact on our consolidated net income and cash
flows in the fourth quarter of 2003, as the financial closing of Springerville
Unit 3 occurred on October 21, 2003. UED operations did not have a significant
impact on net income or cash flow in 2004, nor is it expected to in future
periods.
UNISOURCE ENERGY CONSOLIDATED
OUTLOOK AND STRATEGIES
TERMINATION OF MERGER AGREEMENT
In November 2003, UniSource Energy entered into an Agreement and Plan of
Merger (the Agreement) with Saguaro Acquisition Corp. (Saguaro), an affiliate of
Saguaro Utility Group L.P. (Saguaro LP) that provided for the acquisition of all
of UniSource Energy's outstanding common stock for $25.25 per share by Saguaro.
Saguaro LP was an Arizona limited partnership whose general partner was Sage
Mountain, L.L.C. and whose limited partners included investment funds associated
with Kohlberg Kravis Roberts & Co., L.P., J.P. Morgan Partners, LLC and Wachovia
Capital Partners.
On December 21, 2004, the ACC voted, at the end of a special open meeting,
not to approve the application seeking its approval of the proposed acquisition.
The Agreement provided that in the event that the ACC denies the
acquisition, Saguaro or UniSource Energy could terminate the Agreement, and
UniSource Energy would be obligated to reimburse up to $7 million of Saguaro's
expenses. On December 30, 2004, Saguaro exercised its right to terminate the
Agreement and UniSource Energy paid Saguaro $7 million to cover Saguaro's
expenses.
OPERATING PLANS AND STRATEGIES
Our financial prospects and outlook for the next few years will be affected
by many competitive, regulatory and economic factors. Our plans and strategies
include the following:
o Continue to integrate UES' businesses with UniSource Energy's other
businesses.
o Oversee the construction of Springerville Unit 3 and continue to
enhance the value of existing assets by working with Salt River
Project to facilitate the development of Springerville Unit 4.
o Strengthen the capital structure of TEP by using proceeds from the
UniSource Energy convertible notes, an additional debt issuance at
UniSource Energy and some of our excess cash flows to reduce TEP's
debt.
o Enhance the value of TEP's transmission system while continuing to
provide reliable access to generation for TEP's retail customers and
market access for all generating assets. This will include focusing on
constructing the Tucson - Nogales transmission line, which would
improve reliability for customers of UNS Electric and could eventually
be connected to Mexico's utility system.
o Promote economic development in our service territories.
o Efficiently manage our generation, transmission and distribution
resources and look for ways to control our operating expenses while
maintaining and enhancing reliability and profitability.
o Expand TEP's portfolio of generating and purchased power resources to
meet growing retail energy demand.
o Increase production and sales of Global Solar's thin-film photovoltaic
cells and seek additional investors, or sell all or part of
Millennium's interest, or a combination of both.
o Manage the exit of our other Millennium investments to maximize its
value to shareholders.
K-28
To accomplish our goals, during 2005 we expect TEP to spend approximately
$159 million on capital expenditures and UES to spend approximately $49 million
on capital expenditures.
While we believe that our plans and strategies will continue to have a
positive impact on our financial prospects and position, we recognize that we
continue to be highly leveraged, and as a result, our access to the capital
markets may be limited or more expensive than for less leveraged companies.
RESULTS OF OPERATIONS
---------------------
UniSource Energy recorded Net Income of $46 million in 2004. This compares
with Net Income of $114 million in 2003, and $35 million in 2002. Net Income in
2003 includes an after-tax gain of $67 million for the Cumulative Effect of
Accounting Change from the adoption of Statement of Financial Accounting
Standards No. 143, Accounting for Asset Retirement Obligations (FAS 143). Income
Before Cumulative Effect of Accounting Change was $46 million in 2003. Results
in 2004 include a full year of operations at UNS Gas and UNS Electric; results
in 2003 were for the period August 11 to December 31.
FACTORS IMPACTING NET INCOME IN 2004 COMPARED WITH 2003
o A $196 million increase in Total Operating Revenues resulting from
additional Total Operating Revenues at UNS Gas and UNS Electric of $82
million and $89 million, respectively, and a 2.3% increase in TEP's
number of retail customers.
o Purchased Energy expense, which includes purchased power and purchased
gas expense, was higher by $118 million. This resulted from additional
Purchased Energy expense at UNS Gas and UNS Electric of $51 million
and $57 million, respectively, and a $7 million increase at TEP due to
higher economic wholesale electric purchases in lieu of running
gas-fired generation.
o Other Operations and Maintenance expense (O&M) was higher by $36
million due primarily to additional O&M at UES, $12 million of
expenses related to the proposed acquisition of UniSource Energy by
Saguaro and expenses related to planned and unplanned outages at some
of TEP's generating facilities.
o Scheduled Amortization of TEP's Transition Recovery Asset was $18
million higher than 2003.
o Total Interest Expense increased $2 million due to a full year of
interest expense at UES.
o Income Tax Expense increased $22 million in 2004 due to higher Income
Before Taxes and Cumulative Effect of Accounting Change and a $15
million tax benefit recorded in 2003 resulting from guidance issued by
the IRS clarifying rules on limitations of the use of net operating
loss carry forwards.
o Global Solar recorded a net loss of $5 million in 2004 compared with
losses of $7 million in 2003.
o Millennium's other investments recorded income of $1 million in 2004
compared with losses of $9 million in 2003.
o Results in 2003 included an $11 million pre-tax development fee
received by UED at the financial closing of Springerville Unit 3.
FACTORS IMPACTING NET INCOME IN 2003 COMPARED WITH 2002
o A $133 million increase in Total Operating Revenues resulting from
warm summer weather, a 2.2% increase in TEP's number of retail
customers, and Total Operating Revenues of $47 million at UNS Gas and
$56 million at UNS Electric.
o A $6 million decline in TEP's revenues from Electric Wholesale Sales
is primarily attributable to unplanned outages at several of TEP's
coal-fired generating facilities during the first half of 2003,
unfavorable wholesale opportunities for its gas generation resources
and record retail kWh demand in the third quarter. In addition, TEP
recorded a $2 million increase in reserves against receivables from
California wholesale sales in 2003.
K-29
o Purchased Energy expense, which includes purchased power and purchased
gas expense, was higher by $90 million. This resulted from $31 million
of Purchased Energy expense at UNS Gas and $39 million at UNS
Electric, replacement power costs in the first half of 2003 related to
planned and unplanned outages at TEP's generating facilities, and
increased economic wholesale electric purchases in lieu of running
gas-fired generation.
o Other O&M was higher by $27 million due primarily to $8 million of O&M
at UNS Gas and $6 million at UNS Electric, and increased costs
resulting from planned and unplanned outages at TEP's generating
facilities.
o Higher Total Interest Expense of $12 million related to higher
interest rates under TEP's Credit Agreement, interest expense at UNS
Gas and UNS Electric, and interest expense related to UniSource
Energy's borrowing under a bridge loan for the Citizens Acquisition.
o Despite higher Income Before Taxes and Cumulative Effect of Accounting
Change, income tax expense was $6 million less in 2003 than in 2002,
due primarily to a $15 million tax benefit resulting from guidance
issued by the IRS clarifying rules on limitations of the use of net
operating loss carry forwards.
o Expenses of $3 million related to the proposed acquisition of
UniSource Energy by Saguaro.
o UED's income in 2003 included an $11 million pre-tax development fee
received at the financial closing of Springerville Unit 3.
o 2002 results included a pre-tax coal contract termination fee of $11
million. TEP terminated a coal contract related to the Sundt
Generating Station, eliminating annual take-or-pay payments of
approximately $3 million.
CONTRIBUTION BY BUSINESS SEGMENT
The table below shows the contributions to our consolidated after-tax
earnings by our four business segments.
2004 2003 2002
--------------------------------------------------------------------------------
-Millions of Dollars-
BUSINESS SEGMENT
TEP (1) $ 46 $ 129 $ 55
UNS Gas (2) 6 1 -
UNS Electric (2) 4 2 -
Global Solar (5) (7) (14)
Other (3) (5) (11) (6)
--------------------------------------------------------------------------------
Consolidated Net Income $ 46 $ 114 $ 35
================================================================================
(1) TEP results in 2003 include an after-tax gain of $67 million for the
Cumulative Effect of Accounting Change from the adoption of Statement of
Financial Accounting Standards No. 143, Accounting for Asset Retirement
Obligations (FAS 143).
(2) 2003 results are for the period from August 11, 2003 to December 31, 2003.
(3) Includes: interest expense (net of tax) on the note payable from UniSource
Energy to TEP; costs in 2003 associated with the Citizens acquisition; costs
associated with the failed acquisition of UniSource Energy by Saguaro as
previously discussed; UniSource Energy parent company expenses; income and
losses from other Millennium investments; and income and losses from UED.
LIQUIDITY AND CAPITAL RESOURCES
-------------------------------
K-30
UNISOURCE ENERGY CONSOLIDATED CASH FLOWS
2004 2003 2002
-----------------------------------------------------------------------
-Millions of Dollars-
Cash Provided by (used in):
Operating Activities $ 307 $ 263 $ 176
Investing Activities (156) (351) (271)
Financing Activities (98) 98 (42)
-----------------------------------------------------------------------
Net Increase (Decrease) in Cash $ 53 $ 10 $(137)
=======================================================================
UniSource Energy's consolidated cash flows are provided primarily from
retail and wholesale energy sales at TEP and UES, net of the related payments
for fuel and purchased power. Cash from operations is lowest in the first
quarter and highest in the third quarter due to TEP's summer peaking load.
We use our available cash primarily to:
o finance capital expenditures at TEP and UES;
o pay dividends to shareholders;
o pay income taxes; and
o reduce leverage at TEP by repaying or repurchasing debt and investing
in lease debt.
The primary source of liquidity for UniSource Energy, the parent company,
is dividends it receives from its subsidiaries, primarily TEP, from their cash
flow from operations. Under our tax sharing agreement, our subsidiaries make
income tax payments to UniSource Energy, which makes payments on behalf of the
consolidated group.
As part of our ACC Holding Company Order, we must invest at least 30% of
any proceeds of UniSource Energy equity issuances in TEP until TEP's equity
reaches 37.5% of total capital (excluding capital leases).
As of March 11, 2005, cash and cash equivalents available to UniSource
Energy was approximately $215 million. This balance includes proceeds from
UniSource Energy's Convertible Senior Notes issued March 1, 2005. See
Convertible Senior Notes, below.
OPERATING ACTIVITIES
In 2004, net cash flows from operating activities increased by $44 million
compared with 2003. The following factors contributed to the increase:
o a $114 million increase in cash receipts from retail and wholesale
energy customers, net of fuel and purchased energy costs, due to an
increase in TEP's retail customers and the recognition of a full year
of operations at UNS Gas and UNS Electric;
o the return of a $17 million deposit made in 2003 related to TEP's
second mortgage indentures; partially offset by:
- a $55 million increase in income taxes and other tax paid, net of
income tax refunds received, due primarily to higher taxable
income, higher tax refunds received in 2003, and the recognition
of a full year of operations at UNS Gas and UNS Electric;
- a $10 million increase in wages paid due to the recognition of a
full year of operations at UNS Gas and UNS Electric; and
- $7 million paid to terminate the acquisition agreement with
Saguaro.
INVESTING ACTIVITIES
Net cash used for investing activities was $195 million lower in 2004 than
in 2003, primarily due to the following factors:
o $223 million of cash used for the acquisition of the Citizens' Arizona
gas and electric utility assets in 2003; and
o a $10 million return from a Millennium investment; partially offset by
- a $16 million increase in capital expenditures, primarily
related to UNS Gas and UNS Electric;
K-31
- $13 million used by TEP to purchase a one-third interest in the
Luna Energy Facility; and
- $4 million paid by TEP to purchase Springerville lease debt.
Purchase of Citizens' Arizona Electric and Gas Utility Assets
-------------------------------------------------------------
In August 2003, UniSource Energy used approximately $50 million of its
available cash and borrowed $35 million from a financial institution in the form
of short-term debt to help finance the purchase of the Citizens' Arizona
electric and gas utility assets. The funds were used as an equity contribution
in the capitalization of UES. In October 2003, as required by the debt
agreement, UniSource Energy repaid the $35 million loan with proceeds received
upon the financial close of the Springerville Unit 3 project.
FINANCING ACTIVITIES
Net cash used for financing activities was $98 million in 2004 compared
with net cash received from financing activities of $98 million in 2003. The
following factors primarily contributed to the change:
o In August 2003, UNS Gas issued $100 million of senior unsecured notes,
UNS Electric issued $60 million of senior unsecured notes, and
UniSource Energy obtained a $35 million short-term bridge loan to help
finance the acquisition of the Citizens' Arizona gas and electric
utility assets (see Guarantees and Indemnities, below); partially
offset by:
- TEP repaid $32 million more long-term debt and capital lease
obligations in 2004 than in 2003; and
- TEP paid $9 million in debt issuance costs related to the
refinancing of its Credit Agreement.
As a result of the activities described above, our consolidated cash and
cash equivalents increased to $154 million at December 31, 2004, from $101
million at December 31, 2003. We invest cash balances in high-grade money market
securities with an emphasis on preserving the principal amounts invested.
At March 11, 2005, our consolidated cash balance, including cash
equivalents, was approximately $215 million. This balance includes proceeds from
UniSource Energy's Convertible Senior Notes issued March 1, 2005. See
Convertible Senior Notes, below.
In the event that we experience lower cash from operations in 2005, we will
adjust our discretionary uses of cash accordingly. We believe, however, that we
will continue to have sufficient cash flow to cover our capital needs, as well
as required debt payments and dividends to shareholders.
Convertible Senior Notes
------------------------
On March 1, 2005, UniSource Energy issued $150 million aggregate principal
amount of 4.50% Convertible Senior Notes due 2035 through a domestic offering to
qualified institutional buyers pursuant to Rule 144A under the Securities Act of
1933 (the Act) and to non-U.S. persons in offshore transactions in reliance on
Regulation S under the Act.
Each $1,000 principal amount of notes will be convertible into 26.6667
shares of UniSource Energy common stock at any time, representing a conversion
price of approximately $37.50 per share of UniSource Energy common stock,
subject to adjustment in certain circumstances.
Beginning on March 5, 2010, UniSource Energy will have the option to redeem
the notes, in whole or in part, for cash, at a price equal to 100% of the
principal amount plus accrued and unpaid interest. Holders of the notes will
have the right to require UniSource Energy to repurchase the notes, in whole or
in part, for cash on March 1, 2015, 2020, 2025 and 2030, or if certain specified
fundamental changes involving UniSource Energy occur. The repurchase price will
be 100% of the principal amount of the notes plus accrued and unpaid interest.
In the event of a fundamental change that occurs prior to March 5, 2010,
UniSource Energy may be required to pay a make-whole premium on notes converted
in connection with the fundamental change. The make-whole premium will be
payable in shares of UniSource Energy common stock or the consideration into
which UniSource Energy common stock has been converted or exchanged in
connection with such fundamental change.
A fundamental change involving UniSource Energy will be deemed to have
occurred if (1) certain transactions occur as a result of which there is a
change in control of UniSource Energy; or (2) UniSource Energy common stock
K-32
ceases to be listed on a national securities exchange or quoted on The Nasdaq
National Market or another established automated over-the-counter trading market
in the United States.
The notes may be accelerated upon the occurrence and continuance of an
event of default under the indenture governing the notes. The failure to make
required payments on the notes or comply with the terms of the indenture may
consitute an event of default. In addition, events of default may arise upon the
acceleration of $50 million of indebtedness for borrowed money of UniSource
Energy or TEP, or certain events of bankruptcy involving UniSource Energy or
TEP.
Use of Proceeds
---------------
On March 1, 2005, UniSource Energy used $106 million of the $146 million of
net proceeds from this offering to repay TEP a UniSource Energy debt obligation
in the principal amount of $95 million plus accrued interest of $11 million.
Approximately $25 million represents an equity contribution to TEP. TEP expects
that it will use the proceeds during the first half of 2005 to redeem or
repurchase certain of TEP's existing indebtedness through transactions that may
include negotiated or market purchases, tender offers and redemptions. TEP has
not determined the series of debt to be repaid or repurchased.
On March 10, 2005, UniSource Energy used $10 million of the net proceeds
from this offering to make an equity contribution of $6 million to UNS Gas and
an equity contribution of $4 million to UNS Electric.
UniSource Energy Debt Issuance
------------------------------
UniSource Energy also expects to issue approximately $90 million of
additional indebtedness. Most of the proceeds from this debt will be used to
make an equity investment in TEP. It is anticipated that this equity investment,
together with the proceeds realized through the $95 million inter-company note
repayment, will be used by TEP to retire or repurchase up to $225 million of its
outstanding debt obligations.
GUARANTEES AND INDEMNITIES
In the normal course of business, UniSource Energy and certain
subsidiaries, including TEP, enter into various agreements providing financial
or performance assurance to third parties on behalf of certain subsidiaries. We
entered into these agreements primarily to support or enhance the
creditworthiness of a subsidiary on a stand-alone basis. The most significant of
these guarantees are UES' guarantee of $160 million of aggregate principal
amount of senior unsecured notes issued by UNS Gas and UNS Electric to purchase
the Citizens' Arizona gas and electric system assets, UniSource Energy's
guarantee of approximately $8 million in natural gas and supply payments and
building lease payments for UNS Gas and UNS Electric, and subsidiaries of
Millennium, and Millennium's guarantee of approximately $3 million in
commodity-related payments for MEG at December 31, 2004. To the extent
liabilities exist under the contracts subject to these guarantees, such
liabilities are included in the consolidated balance sheets.
In addition, UniSource Energy and its subsidiaries have indemnified the
purchasers of interests in certain investments from additional taxes due for
years prior to the sale. The terms of the indemnifications provide for no
limitation on potential future payments; however, we believe that we have abided
by all tax laws and paid all tax obligations. We have not made any payments
under the terms of these indemnifications to date.
We believe that the likelihood that UniSource Energy or TEP would be
required to perform or otherwise incur any significant losses associated with
any of these guarantees is remote.
CONTRACTUAL OBLIGATIONS
The following charts display UniSource Energy's consolidated contractual
obligations by maturity and by type of obligation as of December 31, 2004.
-------------------------------------------------------------------------------------------------------------------
UNISOURCE ENERGY'S CONTRACTUAL OBLIGATIONS
- MILLIONS OF DOLLARS -
-------------------------------------------------------------------------------------------------------------------
2011
Payment Due in Years and
Ending December 31, 2005 2006 2007 2008 2009 2010 after Total
-------------------------------------------------------------------------------------------------------------------
Long Term Debt: (1)
Principal(2) $ 2 $ 21 $ 1 $227 $329 $ - $ 679 $1,259
Interest(3) 77 78 77 71 61 62 846 1,272
Capital Lease Obligations:
Springerville Unit 1 85 85 86 85 34 57 430 862
Springerville Coal Handling(4) 17 22 24 18 15 17 98 211
Sundt Unit 4 11 10 12 12 13 13 - 71
K-33
Springerville Common(4) 6 6 6 6 6 7 159 196
Rail Car Lease 1 - - - - - - 1
Operating Leases 2 2 2 2 1 1 4 14
Purchased Obligations:(5)
Coal and Rail Transportation(6) 89 87 79 79 79 79 278 770
Purchase Power(7) 17 4 - - - - - 21
Transmission 6 6 6 1 1 1 1 22
Gas(8) 40 26 13 4 4 4 2 93
Other Long-Term Liabilities:
Pension & Other Post-
Retirement Obligations(9) 10 4 4 5 6 6 171 206
MEH Funding Commitments(10) 2 4 1 - - - - 7
-------------------------------------------------------------------------------------------------------------------
Total Contractual Cash Obligations $365 $ 355 $311 $510 $549 $247 $2,668 $5,005
===================================================================================================================
(1) In March 2005, TEP redeemed the remaining $52 million of its First Mortgage
IDBs (defined below) at par. $21 million was due in 2006, and $31 million was
due in 2008. Interest payments will be reduced by $3 million in 2005 and 2006
and $2 million in 2007 as a result of the bond redemption.
(2) TEP's tax-exempt variable rate bonds (IDBs) in the amount of $329 million
are backed by LOCs issued pursuant to TEP's Credit Agreement. TEP's obligations
under the Credit Agreement are collateralized with Second Mortgage Bonds.
(3) Includes letter of credit and remarketing fees on variable rate debt. The
interest rates for variable rate bonds are estimated using Eurodollar futures
rates for an approximation of LIBOR and adjusted down based on the historical
discount the bonds have had to LIBOR.
(4) Upon commercial operation of Springerville Unit 3 in December 2006,
Tri-State is obligated to reimburse TEP for various operating costs related to
the common facilities, including 14 percent of the Springerville Common Lease
payments and 17 percent of the Springerville Coal Handling Facilities Lease
payments. Similar reimbursement obligations apply if Unit 4 is constructed. TEP
remains the primary obligor under these capital leases. Capital Lease
Obligations do not reflect any reduction associated with this reimbursement.
Upon expiration of the Springerville Coal Handling Facilities and the Common
Leases, TEP is obligated to acquire the facilities at fixed prices of $139
million in 2015, $38 million in 2017 and $68 million in 2021, and each of the
owners of Unit 3 and Unit 4 (if constructed) have the obligation to purchase
from TEP a 14 percent and 17 percent interest, respectively, in such facilities.
The acquisition of the assets upon expiration of the lease terms is excluded
from the table above.
(5) Purchase obligations reflect the minimum contractual obligation under
legally enforceable contracts with contract terms that are both fixed and
determinable. The total amount paid under these contracts depends on the
quantity purchased and transported. UES and TEP's requirements are expected to
be in excess of these minimums. UniSource Energy has excluded open purchase
orders of approximately $3 million expected to be fulfilled in 2005.
(6) TEP expects to spend approximately $180 million annually for the purchase
and transportation of coal through 2010. TEP is unable to estimate how much it
will spend under these contracts beyond 2010 due to the impact of the amended
Springerville coal contract.
(7) Excludes commitments in connection with the SCE and Sempra exchange
agreements. TEP provides firm system capacity to SCE and Sempra in the winter
and spring, and firm system capacity is returned to TEP during the summer. The
agreement with SCE expires in May 2005, and the agreement with Sempra, which
commences in January 2005, extends through September 2005. Also, UniSource
Energy has not included amounts payable to PWCC under UNS Electric's full
requirements power supply agreement as payments under this contract are usage
based with no fixed demand charges and are recovered through the PPFAC
mechanism. We expect to spend approximately $92 million annually under this
contract through May 2008. Amounts also exclude TEP's swap agreements which are
marked to market on a monthly basis. TEP entered into contracts for power
purchases in 2005 totaling $8 million subsequent to December 31, 2004, which are
excluded from the table above.
(8) Amounts include UNS Gas' forward gas purchases and firm transportation
agreements with EPNG and Transwestern. Amounts also include TEP's minimum
transportation obligation with SWG. Natural gas supply and management agreement
commitments with BP are excluded as prices for incremental gas to be supplied
vary. The initial term of the contract extends through August 31, 2005, and
includes an automatic annual one year extension. UNS Gas entered into forward
gas purchases for 2007 and 2008 totaling $1 million subsequent to December 31,
2004, which are excluded from the above table.
(9) These obligations represent TEP and UES' minimum required contributions to
pension plans in 2005 and TEP's expected postretirement benefit costs to cover
medical and life insurance claims as determined by the plans' actuaries. TEP and
UES do not know and have not included pension contributions beyond 2005 due to
the significant impact that returns on plan assets and changes in discount rates
might have on such amounts. TEP funds the postretirement benefit plan on a
pay-as-you-go basis.
(10) These obligations represent Millennium's equity commitments to fund
subsidiaries (Haddington and Valley Ventures) as suitable investments are
identified.
K-34
The following obligations, incurred subsequent to December 31, 2004, are
excluded from the table above, but are included in TEP's forecasted capital
expenditures. In February 2005, TEP signed agreements to complete the
construction of Luna. TEP expects to spend up to an additional $33 million for
its one-third share of the costs of which $30 million will be spent in 2005 and
the remainder in 2006.
Under a settlement agreement signed in March 2005 with the New Mexico
Environmental Department and environmental activist groups, the co-owners of San
Juan will install new technology at the generating station to reduce mercury,
particulate matter, NOx, and SO2 emissions over the next five years. TEP's share
of the cost of new pollution control equipment based on its ownership of San
Juan is anticipated to be approximately $2 million in 2006, $8 million in 2007,
$9 million in 2008, $5 million in 2009, $3 million in 2010 and $1 million in
2011.
MEG conducts its emissions and coal trading activities using certain
contracts which contain provisions whereby MEG may be required to post margin
collateral due to a change in contract values. As of December 31, 2004, MEG had
no cash collateral posted to its trading counterparties.
In September 2004, MEG reduced its bank line of credit from $5 million to
$3 million. The purpose of this line of credit is to issue LOCs to
counterparties to support its emission allowance and coal marketing and trading
activities. As of December 31, 2004, MEG had $2 million in outstanding LOCs, all
of which had expired by the end of February 2005. This facility expired in March
2005 and will not be renewed.
In addition, UniSource Energy has contingent obligations under various
surety bonds that total approximately $0.5 million.
We have reviewed our contractual obligations and provide the following
additional information:
o We do not have any provisions in any of our debt or lease agreements
that would cause an event of default or cause amounts to become due
and payable in the event of a credit rating downgrade.
o None of our contracts or financing structures contains provisions or
acceleration clauses due to changes in our stock price.
DIVIDENDS ON COMMON STOCK
On February 4, 2005, UniSource Energy declared a cash dividend of $0.19 per
share on its Common Stock. The dividend, totaling approximately $7 million, was
paid March 8, 2005 to shareholders of record at the close of business February
15, 2005. During 2004, UniSource Energy paid quarterly dividends to its
shareholders of $0.16, totaling approximately $22 million. In 2003, we paid
quarterly dividends of $0.15 per share, totaling approximately $20 million.
INCOME TAX POSITION
At December 31, 2004, UniSource Energy and TEP had, for federal and state
income tax filing purposes, the following carry forward amounts:
UNISOURCE ENERGY TEP
Amount Expiring Amount Expiring
-Millions of Dollars- Year -Millions of Dollars- Year
------------------------------------------------------------------------------------------------------
NET OPERATING LOSSES $ 18 2021-2022 $ - -
INVESTMENT TAX CREDIT 5 2004-2024 5 2004-2024
AMT CREDIT 100 - 92 -
-------------------------------------------------------------------------------------------------------
The $18 million in NOL carry forwards is subject to limitation due to a
reorganization of certain Millennium entities in December 2002. The future use
of these losses is dependent upon the generation of sufficient future taxable
income at the separate company level. See Critical Accounting Estimates,
Deferred Tax Valuation - TEP and Millennium, below.
TUCSON ELECTRIC POWER COMPANY
K-35
RESULTS OF OPERATIONS
---------------------
The financial condition and results of operations of TEP are currently the
principal factors affecting the financial condition and results of operations of
UniSource Energy on an annual basis. The following discussion relates to TEP's
utility operations, unless otherwise noted.
UTILITY SALES AND REVENUES
Customer growth, weather and other consumption factors affect retail sales
of electricity. Electric wholesale revenues are affected by market prices in the
wholesale energy market, availability of TEP generating resources, and the level
of wholesale forward contract activity.
The table below provides trend information on retail sales by major
customer class and electric wholesale sales made by TEP in the last three years,
as well as weather data for TEP's service territory.
SALES OPERATING REVENUE
2004 2003 2002 2004 2003 2002
------------------------------------------------------------------------------------------------------------
-Millions of kWh- -Millions of Dollars-
ELECTRIC RETAIL SALES:
Residential 3,460 3,390 3,181 $ 315 $ 310 $ 291
Commercial 1,788 1,689 1,605 187 176 169
Industrial 2,226 2,245 2,254 161 160 162
Mining 829 702 693 39 28 28
Public Authorities 240 250 257 17 18 19
------------------------------------------------------------------------------------------------------------
TOTAL ELECTRIC RETAIL SALES 8,543 8,276 7,990 719 692 669
------------------------------------------------------------------------------------------------------------
ELECTRIC WHOLESALE SALES
DELIVERED:
Long-term Contracts 1,227 1,199 982 33 31 29
Other Sales 2,065 2,165 3,035 121 115 125
Transmission - - - 5 6 4
Net Unrealized Gain (Loss) on
Forward Sales of Energy - - - 1 (1) (1)
------------------------------------------------------------------------------------------------------------
TOTAL ELECTRIC WHOLESALE SALES 3,292 3,364 4,017 160 151 157
------------------------------------------------------------------------------------------------------------
TOTAL ELECTRIC SALES 11,835 11,640 12,007 $ 879 $ 843 $ 826
============================================================================================================
WEATHER DATA:
Cooling Degree Days 1,298 1,567 1,439
10-Year Average 1,409 1,458 1,442
%Over/(Under)Prior Year (17%) 9% (3%)
%Over/(Under)10-Year Average (8%) 7% (1%)
Heating Degree Days 1,631 1,327 1,440
10-Year Average 1,481 1,459 1,462
%Over/(Under)Prior Year 23% (8%) (16%)
%Over/(Under)10-Year Average 10% (9%) (1%)
------------------------------------------------------------------------------------------------------------
2004 COMPARED WITH 2003
Total revenues from kWh sales to retail customers increased by $28 million,
or 4%, in 2004, resulting from higher energy demand. Total retail kWh sales
increased by 3% in 2004, despite mild summer weather. Cooling degree days were
17% lower than 2003 and 8% below the 10-year average. Kilowatt-hour sales to
residential customers were 2% higher, while kWh sales to commercial customers
were 6% higher, resulting from customer growth of 2.3% and cool winter weather.
Heating degree days were 23% higher than 2003 and 10% above the 10-year average.
The average price of copper was 59% higher in 2004, leading to increased mining
activity and an 18% increase in kWh sales to TEP's mining customers; revenues
from TEP's mining customers increased $11 million.
Wholesale revenues increased $9 million, or 6%, in 2004, despite a 2%
decrease in wholesale kWh sales. In the first nine months of 2004, TEP benefited
from greater coal plant availability which allowed TEP to sell more excess power
into the wholesale market compared to last year. Wholesale sales opportunities
were limited in the fourth quarter of 2004 due to a planned outage at TEP's
Springerville Unit 1. The average wholesale market price of energy was $44 per
MWh in 2004, compared with $41 per MWh in 2003. See Factors Affecting Results of
Operations, Western Energy Markets, Market Prices, below.
K-36
TEP recorded a $3 million reserve in the second quarter of 2004 and a $2
million reserve in the first quarter of 2003 for revenue subject to refund
related to wholesale sales made to the California Independent System Operator
(CISO) and the California Power Exchange (CPX) in 2001 and 2000. These amounts
are recorded as a reduction to wholesale revenue.
2003 COMPARED WITH 2002
Total retail kWh sales in 2003 increased by 4% compared with 2002. Warmer
summer weather and a 2.2% increase in the number of retail customers more than
offset mild weather during the first six months of 2003. Kilowatt-hour sales to
residential customers were up 7% and kWh sales to commercial customers were up
5% in 2003, resulting from customer growth and warmer weather compared with a
year ago. Revenue from sales to retail customers increased by 3% in 2003,
reflecting higher kWh demand.
Electric wholesale revenues decreased by 4% in 2003. The 4% decline in
wholesale revenues is not as large as the 16% decline in wholesale kWh sales due
to higher average power prices. Average-around-the-clock energy prices based on
the Dow Jones Palo Verde Index for 2003 were $42 per MWh compared with $27 per
MWh during 2002, reflecting higher gas prices. Planned and unplanned outages at
TEP's coal-fired generating plants, particularly in the first six months of
2003, reduced opportunities to sell excess power in the wholesale markets. In
addition, the increase in the regional supply of gas-generated energy allowed
TEP to decrease use of its less efficient gas generation units for wholesale
market opportunities.
Wholesale revenues were reduced by a $2 million reserve for doubtful
accounts in 2003, related to wholesale sales made to CISO and CPX in 2001 and
2000.
OPERATING EXPENSES
2004 COMPARED WITH 2003
FUEL AND PURCHASED POWER EXPENSE
TEP's fuel and purchased power expense, and energy resources for 2004, 2003
and 2002 are detailed below:
GENERATION EXPENSE
2004 2003 2002 2004 2003 2002
------------------------------------------------------------------------------------------------------------
-Millions of kWh- -Millions of Dollars-
Coal-Fired Generation 10,894 10,826 10,756 $ 179 $ 178 $ 178
Gas-Fired Generation 440 439 713 34 32 32
------------------------------------------------------------------------------------------------------------
Total Generation 11,334 11,265 11,469 213 210 210
Purchased Power 1,322 1,153 1,330 72 65 43
------------------------------------------------------------------------------------------------------------
Total Resources 12,656 12,418 12,799 $ 285 $ 275 $ 253
========================================
Less Line Losses and Company Use 821 778 792
--------------------------------------------------------------------
Total Energy Sold 11,835 11,640 12,007
====================================================================
Fuel expense at TEP's generating plants was $213 million in 2004 compared
with $210 million in 2003. Gas-related fuel expense increased $2 million to $34
million, in 2004 due to an 11% increase in market price for gas. Coal-related
fuel expense increased $1 million due to the higher availability and use of
TEP's coal-fired generating plants. See Factors Affecting Results of Operations,
Western Energy Markets, Market Prices, below.
The table below shows the average cost per kWh for TEP's generating plants
by fuel type.
2004 2003 2002
------------------------------------------------------------
-cents per kWh-
Coal 1.64 1.65 1.65
Gas 7.86 7.40 4.45
All fuels 1.88 1.87 1.83
------------------------------------------------------------
K-37
The increase in the regional supply of new gas-generated energy and the
completion of a 500-kV transmission connection allowed TEP to decrease use of
its older, less efficient gas generation units in favor of more economical
purchases of energy in the wholesale market. TEP's Purchased Power expense
increased approximately $7 million, or 11% in 2004.
OTHER OPERATING EXPENSES
Other Operations and Maintenance expense increased by $20 million, or 12%,
in 2004 primarily attributable to increased maintenance costs at the
Springerville and San Juan generating facilities and approximately $8 million of
costs related to the proposed acquisition of UniSource Energy by Saguaro.
Amortization of the Transition Recovery Asset (TRA) increased $18 million
in 2004 compared with 2003. Amortization of the TRA is the result of the 1999
Settlement Agreement (TEP Settlement Agreement) with the ACC, which changed the
accounting method for TEP's generation operations. This item reflects the
recovery, through 2008, of transition recovery assets which were previously
regulatory assets of the generation business. The amount of amortization is a
function of the TRA balance and total kWh consumption by TEP's distribution
customers.
The table below shows estimated TRA amortization and unamortized TRA
balances for 2005-2008.
FUTURE ESTIMATED UNAMORTIZED
TRA AMORTIZATION TRA BALANCE
-Millions of Dollars-
------------------------------------------------------------
2005 $ 57 $ 168
2006 66 102
2007 76 26
2008 26 -
------------------------------------------------------------
OTHER INCOME (DEDUCTIONS)
TEP's Income statement includes inter-company Interest Income of $9 million
for 2004, and $10 million for 2003. This represents Interest Income on the
promissory note TEP received from UniSource Energy in exchange for the transfer
to UniSource Energy of its stock in Millennium in 1998. On UniSource Energy's
Consolidated Statement of Income, this Interest Income, as well as UniSource
Energy's related interest expense, is eliminated as an inter-company
transaction.
INTEREST EXPENSE
Long-Term Debt Interest Expense decreased by $5 million, or 6%, in 2004 due
to lower Letter of Credit fees under TEP's Credit Agreement entered into in
March 2004 and lower interest expense related to the $27 million of 8.5% First
Mortgage Bonds redeemed in July 2004. Interest on Capital Leases increased $2
million in 2004 due to a recalculation of interest expense related to a
capitalized lease transaction.
INCOME TAX EXPENSE
Income Tax Expense Before Cumulative Effect of Accounting Change increased
$14 million in 2004 compared with 2003, due primarily to a $15 million tax
benefit recognized in 2003 resulting from guidance issued by the IRS clarifying
rules on limitations of the use of net operating loss carry forwards.
2003 COMPARED WITH 2002
FUEL AND PURCHASED POWER EXPENSE
Fuel expense at TEP's generating plants was approximately $210 million in
both 2003 and 2002.
TEP's Purchased Power expense increased approximately $22 million, or 51%,
in 2003. In addition to energy purchases made during the third quarter of 2003,
TEP purchased replacement power during the first half of 2003 due to planned and
unplanned outages at some of its generating facilities.
K-38
OTHER OPERATING EXPENSES
Other Operations and Maintenance expense increased by $7 million, or 4%, in
2003 primarily attributable to unplanned outages and longer-than-expected
planned outages at some of TEP's generating facilities during the first quarter
of 2003.
Depreciation and Amortization expense decreased $3 million in 2003. The
adoption of FAS 143 in the first quarter of 2003 resulted in a $6 million
decrease because asset retirement costs are no longer recorded as a component of
depreciation expense. See Critical Accounting Estimates, Accounting for Asset
Retirement Obligations, above.
Amortization of the TRA increased $7 million in 2003 compared with 2002.
OTHER INCOME (DEDUCTIONS)
TEP's income statement includes inter-company Interest Income of $10
million for 2003, and $9 million for 2002. This Interest Income, as well as
UniSource Energy's related interest expense, is eliminated as an inter-company
transaction.
INTEREST EXPENSE
Long-Term Debt Interest Expense increased by $11 million, or 17%, in 2003
due to higher Letter of Credit fees under TEP's Credit Agreement entered into in
November, 2002. Interest on Capital Leases decreased $4 million in 2003 due to
scheduled repayments of lease debt.
INCOME TAX EXPENSE
Income Tax Expense, before Cumulative Effect of Accounting Change,
decreased $15 million in 2003 compared with 2002, due primarily to a $15 million
tax benefit resulting from guidance issued by the IRS clarifying rules on
limitations of the use of net operating loss carry forwards.
CUMULATIVE EFFECT OF ACCOUNTING CHANGE
TEP adopted FAS 143 on January 1, 2003 and recorded a one-time $67 million
after-tax gain. Upon adoption of FAS 143, TEP recorded an asset retirement
obligation of $38 million at its net present value of $1 million, increased
depreciable assets by $0.1 million for asset retirement costs, reversed $113
million of costs previously accrued for final removal recorded in accumulated
depreciation, and reversed previously recorded deferred tax assets of $44
million. Adopting FAS 143 results in a reduction to depreciation expense charged
throughout the year as well because asset retirement costs are no longer
recorded as a component of depreciation expense. For the year 2003, the
reduction in depreciation expense is approximately $6 million. See Critical
Accounting Estimates, Accounting for Asset Retirement Obligations, below.
FACTORS AFFECTING RESULTS OF OPERATIONS
---------------------------------------
COMPETITION
The electric utility industry has undergone significant regulatory change
in the last few years designed to encourage competition in the sale of
electricity and related services. However, the recent experience in California
with deregulation has caused many states, including Arizona, to re-examine the
viability of retail electric deregulation.
As of January 1, 2001, all of TEP's retail customers are eligible to choose
an alternate energy supplier. Currently none of TEP's retail customers are
receiving service from other providers. TEP has met all conditions required by
the ACC to facilitate electric retail competition, including ACC approval of
TEP's direct access tariffs. ESPs must meet certain conditions before
electricity can be sold competitively in TEP's service territory. Examples of
these conditions include ACC certification of ESPs, and execution of and
compliance with direct access service agreements with TEP.
In January 2005, an Arizona Court of Appeals decision became final in which
the Court held invalid certain portions of the ACC rules on retail competition
and related market pricing. Based on this decision, we expect that the ACC will
address the competition rules in an administrative proceeding during 2005. We
cannot predict what changes, if any, the ACC will make to the competition rules.
K-39
TEP competes against gas service suppliers and others that provide energy
services. Other forms of energy technologies may provide competition to TEP's
services in the future, but to date, are not financially viable alternatives for
its retail customers. Self-generation by TEP's large industrial customers could
also provide competition for TEP's services in the future, but has not had a
significant impact to date.
In the wholesale market, TEP competes with other utilities, power marketers
and independent power producers in the sale of electric capacity and energy.
RATES
TEP'S SETTLEMENT AGREEMENT AND RETAIL ELECTRIC COMPETITION RULES
In September 1999, the ACC approved the Retail Electric Competition Rules
(Rules) that provided a framework for the introduction of retail electric
competition in Arizona. In November 1999, the ACC approved the Settlement
Agreement between TEP and certain customer groups related to the implementation
of retail electric competition in Arizona.
The Rules and the Settlement Agreement established:
o a period, November 1999 through 2008, for TEP to transition its
generation assets from a cost of service based rate structure to a
market, or competitive, rate structure;
o the recovery through rates during the transition period of $450
million of stranded generation costs through a fixed competitive
transition charge (fixed CTC);
o capped rates for TEP retail customers through 2008;
o an ACC interim review of TEP retail rates in 2004;
o unbundling of electric services with separate rates or prices for
generation, transmission, distribution, metering, meter reading,
billing and collection, and ancillary services;
o a process for Energy Service Providers (ESPs) to become licensed by
the ACC to sell generation services at market prices to TEP retail
customers;
o access for TEP retail customers to buy market priced generation
services from ESPs beginning in 2000 (currently, no TEP customers are
purchasing generation services from ESPs);
o transmission and distribution services would remain subject to
regulation on a cost of service basis; and
o beginning in 2009, TEP's generation would be market based and its
retail customers would pay the market rate for generation services.
Recent Court Action
-------------------
In January 2005, an Arizona Court of Appeals decision became final in which
the Court held invalid certain portions of the ACC rules on retail competition
and related market pricing. Based on this decision, we cannot predict what
changes, if any, the ACC will make to the Rules and how this decision might
ultimately impact our Settlement Agreement.
2004 General Rate Case Information
----------------------------------
On June 1, 2004, as required by the Settlement Agreement, TEP filed general
rate case information with the ACC. TEP's filing does not propose any change in
retail rates, and under the terms of the Settlement Agreement, no rate case
filed by TEP through 2008 may result in a net rate increase. However, absent the
restriction on raising rates, TEP believes that the data in its filing would
justify an increase in retail rates of 16%.
The general rate case information uses a historical test year ended
December 31, 2003 and establishes, based on TEP's standard offer service, that
TEP is experiencing a revenue deficiency of $111 million. The rate case
information includes, among other things, Springerville Unit 1 costs and other
generation costs including fuel cost in excess of those recovered through
existing rates. The proposed weighted cost of capital for the test year ended
December 31, 2003 is 8.78%, including an 11.5% return on equity (increased from
10.67% currently authorized). The rate case information uses a hypothetical 40%
equity capitalization (excluding capital lease obligations) rather than the
hypothetical 37.5% equity capitalization used in TEP's last general rate case.
TEP's actual equity capitalization (excluding capital lease obligations) at
December 31, 2004 was 27%. In the first half of 2005, TEP expects to increase
common equity to 40% of capitalization (excluding capital lease obligations).
See TEP, Dividends on Common Stock, below for further information regarding
improvements to TEP's capital structure. Despite
K-40
the indicated revenue deficiency, the ACC could conclude that TEP should
decrease rates after June 1, 2005; any such determination would be strongly
opposed by TEP.
A procedural order was issued in February 2005 that outlined how the review
of TEP's general rate case information will proceed. The schedule calls for
staff and intervenor testimony to be filed by June 13, 2005 and hearings, as
appropriate, before the administrative law judge to begin September 12, 2005.
Transition
----------
The Settlement Agreement provides that TEP's fixed CTC will expire when
TEP's $450 million transition asset is fully amortized and recovered or on
December 31, 2008, whichever is earlier. Based on current projections of retail
sales, the transition recovery asset is expected to be fully amortized by
mid-2008. The Settlement Agreement also specifies that TEP's floating
competitive transition charge (floating CTC) will expire on December 31, 2008.
This charge, which moves inversely to changes in market-based generation
services rates, presently appears as a credit on retail customer bills. Based on
current forward pricing in the wholesale energy markets, TEP anticipates that
the floating CTC will continue to appear as a credit on retail customer bills
through 2008. After the expiration of the floating CTC, TEP's rates for
generation services should be market based. TEP anticipates that it will submit
a rate filing to address the rates that will go into effect after the expiration
of the 1999 Settlement Agreement.
Absent any other change to TEP's retail rate structure, including continued
inability to recover actual costs, TEP estimates that the expiration of the
fixed CTC in 2008 (which has provided revenues, on average of .93 cents per kWh
sold) would result in an average decrease in revenues from retail rates of
approximately 12% relative to revenues from current retail rates. However,
absent any other change except the expiration of the fixed CTC, the expiration
in 2008 of the floating CTC would result in market-based generation services
rates which would, based on current pricing in the wholesale energy markets,
produce a retail rate increase in January 2009 of approximately 10-15% relative
to current retail rates.
Given the recent court action described above, the ACC may revise its Rules
and rate methodologies prior to the expiration in 2008 of the Settlement
Agreement. A new structure could replace that established pursuant to the
Settlement Agreement prior to January 2009.
We are operating pursuant to the Settlement Agreement. However, we cannot
predict the future rate methodologies for TEP which the ACC could authorize,
including whether the ACC will permit or require market-based rates for
generation services, reinstate cost of service ratemaking for all or a portion
of TEP's generation services or require an alternate methodology to determine
rates for TEP's generation services. Under any circumstances, TEP will seek
appropriate recovery and return on its investment in assets used to serve its
customers.
In the event that the ACC reinstates cost of service ratemaking for TEP's
generation services and does not allow other factors that have changed in the
intervening years to be considered, significant retail rate decreases could
occur. TEP expects that, in establishing future rates, TEP and the ACC will
review the entirety of the retail rate structure rather than focusing solely on
any one of the elements noted above. Although TEP is unable to predict the type
and level of future retail rates, TEP believes that the 2004 general rate case
information filed with the ACC evidences that there have been a number of
factors that have changed since the Settlement Agreement was approved that
justify increasing or maintaining retail rates at current levels.
WESTERN ENERGY MARKETS
As a participant in the western U.S. wholesale power markets, TEP is
directly and indirectly affected by changes in market conditions and market
participants. TEP competes with other utilities, power marketers and independent
power producers in the sale of electric capacity and energy at market-based
rates in the wholesale market.
As of the end of 2004, electric generating capacity in Arizona has grown to
approximately 25,000 MW; an increase of nearly 60% since 2001. A majority of the
growth over the last three years is the result of 16 new or upgraded gas-fired
generating units with a combined capacity of approximately 9,200 MW. In
addition, the presence of fewer creditworthy counterparties, as well as legal,
political and regulatory uncertainties, has reduced market liquidity and trading
volume.
K-41
MARKET PRICES
The average market price for around-the-clock energy based on the Dow Jones
Palo Verde Index increased in 2004 compared with 2003, as did the average price
for natural gas based on the Permian Index. Average market prices for
around-the-clock energy began to rise back in February 2003 and stayed at these
elevated levels during 2004 due to high natural gas prices from increased demand
and production and storage level concerns. As a result of all of these factors,
TEP's natural gas and purchased power expenses were higher in 2004 than in 2003.
Prices have continued in this range to date; however, we cannot predict whether
these higher prices will continue, or whether changes in various factors that
influence demand and supply will cause prices to fall during 2005.
AVERAGE MARKET PRICE FOR AROUND-THE-CLOCK ENERGY $/MWH
-----------------------------------------------------------------------
Quarter ended December 31, 2004 $ 46
Quarter ended December 31, 2003 38
12 months ended December 31, 2004 44
12 months ended December 31, 2003 41
-----------------------------------------------------------------------
AVERAGE MARKET PRICE FOR NATURAL GAS $/MMBTU
-----------------------------------------------------------------------
Quarter ended December 31, 2004 $ 5.90
Quarter ended December 31, 2003 4.05
12 months ended December 31, 2004 5.44
12 months ended December 31, 2003 4.92
-----------------------------------------------------------------------
TEP typically uses generation from its facilities fueled by natural gas and
purchased power, in addition to energy from its coal-fired facilities, to meet
the summer peak demands of its retail customers and to meet local reliability
needs. Some of these purchased power contracts are price indexed to natural gas
prices. Short-term and spot power purchase prices are also closely correlated to
natural gas prices. Due to its increasing seasonal gas and purchased power
usage, TEP hedges a portion of its total natural gas exposure from plant fuel,
gas-indexed purchased power and spot market purchases with fixed price contracts
for a maximum of three years. TEP purchases its remaining gas fuel needs and
purchased power in the spot and short-term markets.
TEP entered into a Gas Procurement Agreement with SWG effective June 1,
2001 with a primary term of five years. The contract provided for a minimum
volume obligation during the first two years of 10 million MMBtus annually. TEP
negotiated new pricing and a lower minimum annual volume obligation of 4 million
MMBtus for 2004 and subsequently for 2005. In 2004, TEP purchased 5.2 million
MMBtus of gas and expects to use more than the minimum in 2005. In the event
fewer MMBtus are purchased, TEP is obligated to pay only the transportation
component for any shortfall. TEP made payments under this contract, which
include transportation charges, of $34 million in 2004, $34 million in 2003 and
$33 million in 2002. In 2004, the average transportation cost per MMBtu was
$0.43, or $2 million, based on the volume of gas TEP purchased.
We expect the market price and demand for capacity and energy to continue
to be influenced by factors including:
o weather;
o continued population growth in the western U.S.;
o economic conditions in the western U.S.;
o availability of generating capacity throughout the western U.S.;
o the extent of electric utility industry restructuring in Arizona,
California and other western states;
o the effect of FERC regulation of wholesale energy markets;
o the availability and price of natural gas;
o availability of hydropower;
o transmission constraints; and
o environmental regulations and the cost of compliance.
LIQUIDITY AND CAPITAL RESOURCES
K-42
TEP CASH FLOWS
TEP's capital requirements consist primarily of capital expenditures and
optional and mandatory redemptions of long-term debt and capital lease
obligations. As shown in the chart below, during the last three years, TEP had
sufficient cash available after capital expenditures, scheduled debt payments
and capital lease obligations to provide for other investing and financing
activities:
2004 2003 2002
------------------------------------------------------------------------------
-Millions of Dollars-
Cash from Operations $ 275 $ 261 $ 207
Capital Expenditures (116) (122) (103)
Capital Expenditures for Luna Energy (13) - -
Facility Assets
------------------------------------------------------------------------------
Net Cash Flows after Capital Expenditures 146 139 104
------------------------------------------------------------------------------
Debt Maturities (2) (2) (2)
Retirement of Capital Lease Obligations (49) (43) (20)
Proceeds from Investment in
Springerville Lease Debt and Equity 12 12 3
------------------------------------------------------------------------------
Net Cash Flows Available after Required
Payments $ 107 $ 106 $ 85
==============================================================================
During 2005, TEP expects to generate sufficient internal cash flows to fund
its operating activities, construction expenditures, required debt maturities,
and to pay dividends to UniSource Energy. However, TEP's cash flows may vary due
to changes in wholesale revenues, changes in short-term interest rates, and
other factors. TEP currently has $60 million available under its Revolving
Credit Facility which it may borrow if cash flows fall short of expectations or
if monthly cash requirements temporarily exceed available cash balances.
OPERATING ACTIVITIES
In 2004, net cash flows from operating activities increased by $14 million
compared with 2003. The following factors contributed to the increase:
o a $29 million increase cash receipts from retail and wholesale
electric customers, net of fuel and purchased energy costs, due
primarily to higher retail energy demand;
o the return of a $17 million deposit made in 2003 related to TEP's
second mortgage indenture; and
o a $12 million decrease in total interest paid due primarily to lower
interest rates on TEP's Credit Facility, which was refinanced in March
2004, and lower capital lease obligations outstanding; partially
offset by:
- a $20 million receipt of interest in 2003 related to the
inter-company note to UniSource Energy;
- a $31 million increase in income taxes and other tax paid, net of
income tax refunds received, due to higher estimated taxable
income for 2004 and higher tax refunds received in 2003;
- a $5 million increase in wages paid due to higher incentive
compensation.
In January 2004, TEP borrowed $20 million under its revolving credit
facility and repaid it within 30 days. At December 31, 2004, there were no
outstanding borrowings under the revolving credit facility.
INVESTING ACTIVITIES
Net cash used for investing activities was $15 million higher in 2004
compared with 2003, due primarily to the purchase of the Luna Energy Facility
for $13 million and a $4 million investment in Springerville Lease Debt. These
expenditures were partially offset by $4 million of lower capital expenditures
at TEP, primarily the result of the timing of expected projects. We expect TEP's
capital expenditures to be approximately $159 million in 2005. TEP's capital
budget is established annually; however, it is subject to change as
opportunities and requirements arise related to our service territory.
Investments in Springerville Lease Debt and Equity
--------------------------------------------------
PRINCIPAL AVERAGE
DATE AMOUNT DEBT PURCHASED COUPON RATE
--------------------------------------------------------------------------------
K-43
January 2002 $96 million Springerville Coal Handling Lease Debt 14.3%
May 2002 3 million Springerville Unit 1 Lease Debt 10.7%
September 2002 33 million Springerville Unit 1 Lease Debt 10.6%
March 2004 4 million Springerville Unit 1 Lease Debt 10.7%
--------------------------------------------------------------------------------
As of March 11, 2005, TEP's total investment in Springerville Lease Debt
was approximately $163 million, at yields at date of purchase ranging from 8.9%
to 12.7%.
See Note 10 of Notes to Consolidated Financial Statements - Debt and
Capital Lease Obligations
Capital Expenditures
--------------------
TEP's forecasted capital expenditures for the next five years are: $159
million in 2005, $141 million in 2006, $133 million in 2007, $124 million in
2008, and $198 million in 2009. Forecasted capital expenditures for 2009 include
$54 million of additional local generation facilities to support anticipated
growth in TEP's service territory. These estimated capital expenditures for
2005-2009 break down in the following categories:
o $447 million for transmission, distribution and other facilities;
o $158 million for production facilities;
o $54 million for new generation in service in 2010;
o $36 million for the Luna Energy Facility;
o $35 million for environmental projects; and
o $25 million for renewable energy projects, including the expansion of
TEP's solar generation portfolio.
These estimated expenditures include costs for TEP to comply with current
federal and state environmental regulations. All of these estimates are subject
to continuing review and adjustment. Actual construction expenditures may be
different from these estimates due to changes in business conditions,
construction schedules, environmental requirements, and changes to TEP's
business arising from retail competition. TEP plans to fund these expenditures
through internally generated cash flow.
If TEP obtains the required environmental permits to proceed with the
planned transmission line to Nogales, it would expect to fund an additional $76
million during this five year period to complete the line. See Item 1. Business,
Tucson Electric Utility Operations, Transmission Access, Tucson to Nogales
Transmission Line.
In addition to TEP's forecasted capital expenditures for construction,
TEP's other capital requirements include its required debt maturities and
capital lease obligations. See Note 10 of Notes to Consolidated Financial
Statements - Debt and Capital Lease Obligations.
FINANCING ACTIVITIES
Net cash used for financing activities was $40 million lower in 2004
compared with 2003. The following factors contributed to the decrease:
o a decrease of $49 million in dividends paid by TEP to UniSource
Energy; and
o an increase in other net cash inflows of $33 million due primarily to
an $11 million decrease in inter-company tax payments to UniSource
Energy and an increase of $5 million from inter-company transactions
with UES; partially offset by,
o $34 million more in payments by TEP for long-term debt and capital
lease obligations in 2004 than in 2003; and
o $9 million paid in debt issuance costs related to the refinancing of
its Credit Agreement.
K-44
Inter-Company Note from UniSource Energy
----------------------------------------
On March 1, 2005, UniSource Energy repaid to TEP a debt obligation in the
principal amount of $95 million plus accrued interest of $11 million. TEP
expects that it will use the proceeds during the first half of 2005 to redeem or
repurchase certain of its existing indebtedness through transactions that may
include negotiated or market purchases, tender offers and redemptions. TEP has
not determined the series of debt to be repaid or repurchased.
Bond Issuance and Redemption
----------------------------
In July 2004, TEP redeemed the remaining $27 million of its 8.5% First
Mortgage Bonds which were due in 2009. TEP paid a premium of $0.4 million
related to this redemption. A portion of this premium was expensed immediately,
while the remainder is being amortized over the original life of the bonds.
During 2004, TEP also made required sinking fund payments of $2 million. During
2003, TEP purchased and retired $0.4 million of its 8.50% First Mortgage Bonds
due in 2009 and made required sinking fund payments of $2 million.
In March 2005, TEP redeemed $21 million of its 7.5% First Mortgage Bonds at
par, which were due in 2006. TEP also redeemed in March 2005 $31 million of its
6.1% First Mortgage Bonds at par, which were due in 2008.
Capital Lease Obligations
-------------------------
At December 31, 2004, TEP had $755 million of total capital lease
obligations on its balance sheet. The table below provides a summary of the
outstanding lease amounts at December 31, 2004.
BALANCE AT
LEASED ASSET 12/31/2004 EXPIRATION
--------------------------------------------------------------------------------
- In Millions -
Springerville Unit 1 $ 460 2014
Springerville Coal Handling Facilities 126 2015
Springerville Common Facilities 105 2020
Sundt Unit 4 63 2010
Other Leases 1 2006
-------------------------------------------------------------------
Total Capital Lease Obligations $ 755
===================================================================
TEP will not own these assets at the expiration of the lease. TEP may renew
the leases or purchase the leased assets at such time. These renewal and
purchase options are generally for fair market value as determined at that time.
TEP Credit Agreement
--------------------
On March 25, 2004, TEP entered into a new $401 million Credit Agreement.
The agreement replaces the credit facilities provided under TEP's $401 million
Credit Agreement that would have expired in 2006. The new Credit Agreement
includes a $60 million revolving credit facility for general corporate purposes
and a $341 million letter of credit facility, to support $329 million aggregate
principal amount of tax-exempt variable rate bonds. The Credit Agreement has a
five year term through June 30, 2009 and is secured by $401 million in aggregate
principal amount of Second Mortgage Bonds issued under TEP's General Second
Mortgage Indenture.
The Credit Agreement contains a number of restrictive covenants, including
restrictions on additional indebtedness, liens, sale of assets and
sale-leasebacks. The Credit Agreement also contains several financial covenants
including: (a) minimum consolidated tangible net worth, (b) a minimum cash
coverage ratio, and (c) a maximum leverage ratio. Under the terms of the Credit
Agreement, TEP may pay dividends so long as it maintains compliance with the
Credit Agreement. The Credit Agreement also provides that under certain
circumstances, certain regulatory actions could result in a required reduction
of the commitments. As of December 31, 2004, TEP was in compliance with the
terms of the Credit Agreement.
K-45
Upon the occurrence and continuance of an event of default under the Credit
Agreement, outstanding borrowings under the Credit Agreement may become
immediately due and payable. Events of default under the Credit Agreement
include failure to make payments required thereunder, certain events of
bankruptcy or commencement of similar liquidation or reorganization proceedings
or a change of control of TEP. In addition, an event of default may occur if TEP
or certain specified subsidiaries fail to make when due any payment of principal
(regardless of amount) in respect of certain indebtedness the aggregate
principal amount of which exceeds $15 million or if any such indebtedness
becomes due or capable of being called for payment prior to its scheduled
maturity.
The letter of credit fee of 2.35% on the new facility is significantly
lower than the previous Credit Agreement's weighted average letter of credit fee
of approximately 5%. Unreimbursed drawings on a letter of credit bear a variable
rate of interest based on LIBOR plus 2.25% per annum. Interest savings in 2004
were partially offset by the March 2004 write-off of $2 million of fees
associated with the prior facility that were capitalized and being amortized
through 2006. Fees of $9 million associated with the entry into the new facility
are being amortized through June 2009. This expense is included in Long-Term
Debt Interest Expense in UniSource Energy and TEP's income statements.
At December 31, 2004, TEP had no outstanding borrowings under the revolving
credit facility. If TEP borrows under the revolving credit facility, the
borrowing costs would be at a variable interest rate consisting of a spread over
LIBOR or an alternate base rate. The spread is based upon a pricing grid tied to
TEP's leverage. The per annum rate currently in effect on borrowings under TEP's
revolving credit facility, based on its leverage, is LIBOR plus 2.25%. If TEP's
leverage were to change, the spread over LIBOR could range from 1.50% to 2.25%.
TEP also pays a commitment fee of 0.50% on the unused portion of the revolving
credit facility.
TEP expects to refinance its current Credit Agreement in the first half of
2005.
Springerville Common Facilities Leases
--------------------------------------
In 1985, TEP sold and leased back its undivided one-half ownership interest
in the common facilities at the Springerville Generating Station. Under the
terms of the Springerville Common Facilities Leases, TEP must periodically
arrange for refinancing or refunding of the secured notes underlying the leases
prior to the named date in order to avoid a special event of loss. TEP was
required to arrange for the refinancing of the lease debt prior to the special
event of loss date of June 30, 2003 or the leases would have been terminated and
TEP would have been required to repurchase the facilities for $125 million.
TEP finalized the arrangements for the refinancing of $70 million of lease
debt on June 26, 2003 and the special event of loss date was reset for June 30,
2006. Interest on the new debt is payable at LIBOR plus 4.25%. The LIBOR rate is
reset every six months and the rate in effect on December 31, 2004 was 1.92%,
and was 0.99% on December 31, 2003, which resulted in a total interest rate on
the lease debt of 6.17% at December 31, 2004 and 5.24% at December 31, 2003.
Prior to the refinancing, the interest rate was LIBOR plus 2.50%. TEP will be
required to arrange for the refinancing of the lease debt prior to the special
event of loss date of June 30, 2006 or TEP will be required to repurchase the
facilities for approximately $127 million.
Tax-Exempt Local Furnishing Bonds
---------------------------------
TEP has financed a substantial portion of utility plant assets with
industrial development revenue bonds issued by the Industrial Development
Authorities of Pima County and Apache County. The interest on these bonds is
excluded from gross income of the bondholder for federal tax purposes. This
exclusion is allowed because the facilities qualify as "facilities for the local
furnishing of electric energy" as defined by the Internal Revenue Code. These
bonds are sometimes referred to as "tax-exempt local furnishing bonds." To
qualify for this exclusion, the facilities must be part of a system providing
electric service to customers within not more than two contiguous counties. TEP
provides electric service to retail customers in the City of Tucson and certain
other portions of Pima County, Arizona and to Fort Huachuca in contiguous
Cochise County, Arizona.
TEP has financed the following facilities, in whole or in part, with the
proceeds of tax-exempt local furnishing bonds: Springerville Unit 2, Sundt Unit
4, a dedicated 345-kV transmission line from Springerville Unit 2 to TEP's
retail service area (the Express Line), and a portion of TEP's local
transmission and distribution system in the Tucson metropolitan area. As of
December 31, 2004, TEP had approximately $584 million of tax-exempt local
furnishing bonds outstanding. Approximately $331 million in principal amount of
such bonds financed Springerville Unit 2 and the Express Line. In addition,
approximately $53 million of remaining lease debt related to the Sundt Unit 4
lease obligation was issued as tax-exempt local furnishing bonds.
K-46
Various events might cause TEP to have to redeem or defease some or all of
these bonds:
o formation of an RTO or ISO;
o asset divestiture;
o changes in tax laws; or
o changes in system operations.
TEP believes that its qualification as a local furnishing system should not
be lost so long as (1) the RTO or ISO would not change the operation of the
Express Line or the transmission facilities within TEP's local service area, (2)
the RTO or ISO allows pricing of transmission service such that the benefits of
tax-exempt financing continue to accrue to retail customers, and (3) energy
produced by Springerville Unit 2 and by TEP's local generating units continues
to be consumed in TEP's local service area. However, there is no assurance that
such qualification can be maintained. Any redemption or defeasance of these
bonds, subsequent to the debt retirements contemplated in TEP's planned
recapitalization, would likely require the issuance and sale of higher cost
taxable debt securities in the same or a greater amount.
Mortgage Indentures
-------------------
TEP's first mortgage indenture and second mortgage indenture create liens
on and security interests in most of TEP's utility plant assets. Springerville
Unit 2, which is owned by San Carlos, is not subject to these liens and security
interests. TEP's mortgage indentures allow TEP to issue additional mortgage
bonds on the basis of: (1) a percentage of net utility property additions and/or
(2) the principal amount of retired mortgage bonds. The amount of bonds that TEP
may issue is also subject to a net earnings test under each mortgage indenture.
TEP's Credit Agreement contains limits on the amount of First and Second
Mortgage Bonds that may be outstanding. The Credit Agreement allows no more than
$222 million of First Mortgage Bonds to be outstanding, and no more than a total
of $650 million in First and Second Mortgage Bonds to be outstanding. At
December 31, 2004, TEP had $191 million of First Mortgage Bonds and a total of
$592 million in First and Second Mortgage Bonds outstanding. Although the first
and second mortgage indentures would allow TEP to issue additional bonds based
on property additions and/or retired bond credits, the limits imposed by the
Credit Agreement are more restrictive and are currently the governing
limitations.
TEP also has the ability to release property from the liens of the mortgage
indentures on the basis of net property additions and/or retired bond credits.
TEP's Credit Agreement that was in effect in 2003 limited the amount of property
that could be released from the second mortgage indenture to $25 million. As a
result, TEP deposited $17 million in cash with the second mortgage trustee in
the fourth quarter of 2003 in conjunction with the release of $42 million in
property from its mortgage indentures related to the Springerville Unit 3
transaction. The $17 million deposit was refunded to TEP during 2004. This
limitation was removed when TEP refinanced its Credit Agreement in March 2004.
CONTRACTUAL OBLIGATIONS
The following charts display TEP's contractual obligations as of December
31, 2004 by maturity and by type of obligation.
--------------------------------------------------------------------------------------------------------------------------
TEP'S CONTRACTUAL OBLIGATIONS
- MILLIONS OF DOLLARS -
--------------------------------------------------------------------------------------------------------------------------
2011
Payment Due in Years and
Ending December 31, 2005 2006 2007 2008 2009 2010 after Total
--------------------------------------------------------------------------------------------------------------------
Long-Term Debt:
Principal $ 2 $21 $ 1 $ 167 $ 329 $ - $ 579 $ 1,099
Interest 66 67 66 62 54 56 830 1,201
Capital Lease Obligations:
Springerville Unit 1 85 85 86 85 34 57 430 862
Springerville Coal Handling 17 22 24 18 15 17 98 211
Sundt Unit 4 11 10 12 12 13 13 - 71
Springerville Common 6 6 6 6 6 7 159 196
Rail Car Lease 1 - - - - - - 1
K-47
Operating Leases 1 1 1 1 1 1 - 6
Purchase Obligations:
Coal and Rail Transportation 89 87 79 79 79 79 278 770
Purchase Power 17 4 - - - - - 21
Gas 2 - - - - - - 2
Other Long-Term Liabilities:
Pension & Other Post
-Retirement Obligations 9 4 4 5 6 6 171 205
--------------------------------------------------------------------------------------------------------------------
Total Contractual Cash Obligations $ 306 $ 307 $ 279 $ 435 $ 537 $ 236 $2,545 $ 4,645
====================================================================================================================
See UniSource Energy Consolidated, Liquidity and Capital Resources,
Contractual Obligations, above, for a description of these obligations.
We have no other commercial commitments to report.
We have reviewed our contractual obligations and provide the following
additional information:
o TEP's Credit Agreement contains pricing for its Revolving Credit
Facility based on TEP's leverage ratio. A change in TEP's leverage
ratio can cause an increase or decrease in the amount of interest TEP
pays on its borrowings.
o TEP's Credit Agreement contains certain financial and other
restrictive covenants, including interest coverage, leverage and net
worth tests. Failure to comply with these covenants would entitle the
lenders to accelerate the maturity of all amounts outstanding. At
December 31, 2004, TEP was in compliance with these covenants. See TEP
Credit Agreement, above.
o TEP conducts its wholesale trading activities under the Western System
Power Pool Agreement (WSPP) which contains provisions whereby TEP may
be required to post margin collateral due to a change in credit rating
or changes in contract values. As of December 31, 2004, TEP has not
been required to post such collateral.
DIVIDENDS ON COMMON STOCK
TEP declared and paid dividends of $32 million in 2004, $80 million in 2003
and $35 million in 2002. UniSource Energy is a primary holder of TEP's common
stock.
TEP can pay dividends if it maintains compliance with the TEP Credit
Agreement and certain financial covenants, including a covenant that requires
TEP to maintain a minimum level of net worth. As of December 31, 2004, the
required minimum net worth was $352 million. TEP's actual net worth at December
31, 2004 was $415 million. As of December 31, 2004, TEP was in compliance with
the terms of the Credit Agreement. See Financing Activities - TEP Credit
Agreement, above.
The ACC Holding Company Order stated that TEP may not pay dividends to
UniSource Energy in excess of 75% of its earnings until TEP's common equity
equals 37.5% of total capitalization (excluding capital lease obligations). The
Citizens Settlement Agreement, as approved by the ACC, modified this dividend
limitation so that it will remain in place until TEP's common equity equals 40%
of total capitalization (excluding capital lease obligations). As of December
31, 2004, TEP's common equity (as determined by the ACC for the purpose of this
limitation) equaled 27% of total capitalization (excluding capital lease
obligations).
In the first half of 2005, TEP expects to increase its common equity to 40%
of total capitalization (excluding capital lease obligations). It is anticipated
that an equity investment from UniSource Energy, together with the proceeds
realized through the $95 million inter-company note repayment, will be used by
TEP to retire or repurchase up to $225 million of its outstanding debt
obligations.
In addition to these limitations, the Federal Power Act states that
dividends shall not be paid out of funds properly included in capital accounts.
Although the terms of the Federal Power Act are unclear, we believe that there
is a reasonable basis to pay dividends from current year earnings. Therefore,
TEP declared its 2004, 2003 and 2002 dividends from its current year earnings
since TEP had an accumulated deficit, rather than positive retained earnings.
K-48
UNS GAS
RESULTS OF OPERATIONS
---------------------
UniSource Energy formed two operating companies, UNS Gas and UNS Electric,
to acquire the Arizona electric and gas assets from Citizens, as well as an
intermediate holding company, UES, to hold the common stock of UNS Gas and UNS
Electric. Results of operations in 2003 for UNS Electric and UNS Gas cover the
period from August 11, 2003, the date the assets were acquired from Citizens, to
December 31, 2003.
In its first full year of operations, UNS Gas' net income for 2004 was
approximately $6 million. We expect operations at UNS Gas to vary with the
seasons, with peak energy usage occurring in the winter months.
As of December 31, 2004, UNS Gas had approximately 133,400 retail
customers, a 5% increase from last year. The table below shows UNS Gas' therm
sales and revenues for 2004 and 2003. Results in 2003 are for the period August
11 to December 31.
Sales Revenue
2004 2003* 2004 2003*
--------------------------------------------------------------------------------
- Millions of Therms - - Millions of Dollars -
RETAIL THERM SALES:
Residential 71 25 $ 76 $ 25
Commercial 29 12 27 11
Industrial 3 1 2 1
Public Authorities 7 3 6 2
--------------------------------------------------------------------------------
TOTAL RETAIL THERM SALES 110 41 111 39
Transport - - 3 1
Negotiated Sales Program (NSP) 21 13 12 7
--------------------------------------------------------------------------------
TOTAL THERM SALES 131 54 $ 126 $ 47
================================================================================
*For the period August 11 to December 31, 2003
Through a Negotiated Sales Program (NSP) approved by the ACC, UNS Gas
supplies natural gas to some of its large transportation customers.
Approximately one half of the margin earned on these NSP sales is retained by
UNS Gas, while the remainder benefits retail customers through a credit to the
Purchased Gas Adjustor (PGA) mechanism which reduces the gas commodity price.
See Factors Affecting Results of Operations, Rates and Regulation, Purchased Gas
Adjustor, below.
The table below provides summary financial information for UNS Gas.
2004 2003*
-------------------------------------------------------------------
- Millions of Dollars -
Gas Revenues $ 127 $46
Other Revenues 2 1
-----------------------------------------------------------------
Total Operating Revenues 129 47
Purchased Energy Expense 82 31
-----------------------------------------------------------------
Utility Gross Margin 47 16
-----------------------------------------------------------------
Other Operations and Maintenance Expense 23 8
Depreciation and Amortization 5 2
Taxes other than Income Taxes 3 2
-----------------------------------------------------------------
Total Other Operating Expenses 31 12
-----------------------------------------------------------------
Operating Income 16 4
-----------------------------------------------------------------
Total Interest Expense 6 2
Income Tax Expense 4 1
-----------------------------------------------------------------
NET INCOME $ 6 $ 1
=================================================================
*For the period August 11 to December 31, 2003
K-49
FACTORS AFFECTING RESULTS OF OPERATIONS
---------------------------------------
RATES AND REGULATION
ACC ORDER ON CITIZENS' ASSET ACQUISITION
On July 3, 2003, the ACC issued an order approving the acquisition of
Citizens' Arizona gas assets. Concurrent with the closing of the acquisition,
retail rate increases for customers of UNS Gas went into effect on August 11,
2003. Key provisions of the order include:
o 20.9% overall increase in retail rates through a base rate increase.
o Restricts the filing of a general rate case until August 2006 and any
resulting rate increase shall not become effective prior to August 1,
2007.
o Limits dividends payable by UNS Gas to UniSource Energy to 75% of
earnings until the ratio of common equity to total capitalization
reaches 40%.
ENERGY COST ADJUSTMENT MECHANISMS
UNS Gas' retail rates include a PGA mechanism intended to address the
volatility of natural gas prices and allows UNS Gas to recover its costs through
a price adjustor. The PGA charge may be changed monthly based on an ACC approved
mechanism that compares the twelve-month rolling average gas cost to the base
cost of gas, subject to limitations on how much the price per therm may change
in a twelve month period. The difference between the actual cost of UNS Gas' gas
supplies and transportation contracts and that currently allowed by the ACC are
deferred and recovered or repaid through the PGA mechanism. When under or over
recovery trigger points are met, UNS Gas may request a PGA surcharge or
surcredit with the goal of collecting or returning the amount deferred from or
to customers over a twelve month period.
In January 2005, UNS Gas requested the ACC approve a PGA surcharge of $0.06
per therm beginning April 1, 2005 and removed one year later, to recover its
excess gas purchase costs. On March 3, 2005, the ACC staff in its proposed
order, recommended implementation of a $0.05 per therm surcharge beginning April
1, 2005 to recover the uncollected PGA balance. The previous PGA surcharge of
$0.1155 per therm took effect October 1, 2003 and ended November 1, 2004.
LIQUIDITY AND CAPITAL RESOURCES
-------------------------------
UNS Gas' capital requirements consist primarily of capital expenditures. In
2004, capital expenditures were approximately $19 million. During 2005, UNS Gas
expects to generate sufficient internal cash flows to fund its operating
activities and a portion of its construction expenditures. Remaining cash needed
for construction expenditures is expected to be obtained through a combination
of additional equity investments from UniSource Energy and borrowings under a
revolving credit facility that UES expects to establish.
In January 2005, UNS Gas established a short-term inter-company promissory
note to UniSource Energy, by which it may borrow up to $10 million for general
corporate purposes. This note bears an interest rate of LIBOR plus 2.50% and
expires January 16, 2006.
On March 10, 2005, UniSource Energy contributed an additional $6 million in
equity to UNS Gas. On March 10, 2005, UNS Gas repaid the $6 million outstanding
on this note from the proceeds of the $6 million equity contribution described
above.
The table below provides summary information for operating cash flow and
capital expenditures for 2004 and 2003.
2004 2003*
-----------------------------------------------------------------------
-Millions of Dollars-
Net Cash Flows - Operating Activities $ 21 $ 5
Capital Expenditures 19 9
-----------------------------------------------------------------------
*For the period August 11 to December 31, 2003
K-50
Forecasted capital expenditures for UNS Gas are as follows:
2005 2006 2007 2008 2009
--------------------------------------------------------------------------------
- Millions of Dollars -
UNS Gas $ 23 $ 20 $ 18 $ 19 $ 21
--------------------------------------------------------------------------------
Senior Unsecured Notes
----------------------
On August 11, 2003, UNS Gas issued a total of $100 million of aggregate
principal amount of senior unsecured notes in a private placement consisting of
$50 million of 6.23% Notes due in 2011 and $50 million of 6.23% Notes due in
2015. Proceeds from the note issuance were paid to Citizens to purchase the
Arizona gas system assets. The notes are guaranteed by UES.
The note purchase agreements for UNS Gas contain certain restrictive
covenants, including restrictions on transactions with affiliates, mergers,
liens to secure indebtedness, restricted payments, incurrence of indebtedness,
and minimum net worth. Consolidated Net Worth, as defined by the note purchase
agreement for UNS Gas, is approximately equal to the balance sheet line item,
Common Stock Equity. The table below outlines the actual and required minimum
net worth levels of UES and UNS Gas at December 31, 2004.
COMPANY REQUIRED NET WORTH ACTUAL NET WORTH
--------------------------------------------------------------------------------
- Millions of Dollars -
UES $ 50 $ 100
UNS Gas 43 59
--------------------------------------------------------------------------------
The incurrence of indebtedness covenant requires UNS Gas to meet certain
tests before additional indebtedness may be incurred. These tests include:
o A ratio of Consolidated Long-Term Debt to Consolidated Total
Capitalization of no greater than 0.65 to 1.00.
o An Interest Coverage Ratio (a measure of cash flow to cover interest
expense) of at least 2.50 to 1.00.
However, UNS Gas may, without meeting these tests, refinance indebtedness
and incur short-term debt in an amount not to exceed $7 million. UNS Gas may not
declare or make distributions or dividends (restricted payments) on its common
stock unless (a) immediately after giving effect to such action no default or
event of default would exist under its note purchase agreement and (b)
immediately after giving effect to such action, it would be permitted to incur
an additional dollar of indebtedness under the debt incurrence test. As of
December 31, 2004, UNS Gas was in compliance with the terms of its note purchase
agreement.
The senior unsecured notes may be accelerated upon the occurrence and
continuance of an event of default under the note purchase agreement. Events of
default under the note purchase agreement include failure to make payments
required thereunder, certain events of bankruptcy or commencement of similar
liquidation or reorganization proceedings or a change of control of UES or UNS
Gas. In addition, an event of default may occur if UNS Gas, UES or UNS Electric
defaults on any payments required in respect of certain indebtedness that is
outstanding in an aggregate principal amount of at least $4 million or if any
such indebtedness becomes due or capable of being called for payment prior to
its scheduled payment date or if there is a default in the performance or
compliance with the other terms of such indebtedness and, as a result of such
default, such indebtedness has become, or has been declared, due and payable,
prior to its scheduled payment date.
CONTRACTUAL OBLIGATIONS
UNS GAS SUPPLY CONTRACTS
UNS Gas has a natural gas supply and management agreement with BP Energy
Company (BP). Under the contract, BP manages UNS Gas' existing supply and
transportation contracts and its incremental requirements. The initial term of
the agreement extends through August 31, 2005. The term of the agreement is
automatically extended one year on an annual basis unless either party provides
180 days notice of its intent to terminate. Prices for incremental gas supplied
by BP will vary based upon the period during which the gas is delivered.
K-51
UNS Gas hedges its gas supply prices by entering into fixed price forward
contracts at various times during the year to provide more stable prices to its
customers. These purchases are made up to three years in advance with the goal
of hedging at least 45% and not more than 80% of the expected monthly gas
consumption with fixed prices prior to entering into the month. UNS Gas hedged
approximately 60% of its expected monthly consumption for the 2004/2005 winter
season (November through March). Additionally, UNS Gas has approximately 50% of
its expected gas consumption hedged for April through July of 2005, and 35%
hedged for the period August 2005 through July of 2006.
UNS Gas has firm transportation agreements with El Paso Natural Gas (EPNG)
and Transwestern Pipeline Company (Transwestern) with combined capacity
sufficient to meet its load requirements.
In July 2003, FERC required the conversion of UNS Gas' full requirements
status under the EPNG agreement to contract demand starting on September 1,
2003. UNS Gas now has specific volume limits in each month and specific receipt
point rights from the available supply basins (San Juan and Permian). The
average daily capacity rights of UNS Gas after conversion to contract demand is
approximately 870,000 therms per day, with an average of 1,200,000 therms per
day in the winter season (November through March). These changes have also
reduced the amount of less expensive San Juan gas available to UNS Gas. The
impact, however, is not expected to be material. The annual cost of the EPNG
capacity after conversion to contract demand did not change. These costs will be
the same through 2005 (pending a 2006 EPNG rate case after which the rates are
expected to increase) as under UNS Gas' existing full requirements contract.
This contract expires in August 2011.
UNS Gas has capacity rights of 250,000 therms per day on the San Juan
Lateral and Mainline of the Transwestern pipeline. The Transwestern pipeline
principally delivers gas to the portion of UNS Gas' distribution system serving
customers in Flagstaff and Kingman, Arizona, and also delivers gas to UNS Gas'
facilities serving the Griffith Power Plant in Mohave County. This contract
expires in January 2007.
The aggregate annual minimum transportation charges are expected to be
approximately $4 million and $3 million for the EPNG and Transwestern contracts,
respectively. These costs are passed through to our customers via the Purchased
Gas Adjustor mechanism. See UniSource Energy Services, Factors Affecting Results
of Operations, Rates and Regulations, Energy Cost Adjustment Mechanisms, above.
DIVIDENDS ON COMMON STOCK
The Citizens Settlement Agreement, as approved by the ACC, limits dividends
payable by UNS Gas to 75% of earnings until the ratio of common equity to total
capitalization reaches 40%. At December 31, 2004, the ratio of common equity to
total capitalization for UNS Gas was 37%.
An equity investment of $6 million from UniSource Energy on March 10, 2005
increased UNS Gas' ratio of common equity to total capitalization to 40%.
The note purchase agreements for UNS Gas contain restrictive covenants
including restrictions on dividends. According to the note purchase agreements
UNS Gas may not declare or make distributions or dividends (restricted payments)
on its common stock unless, (a) immediately after giving effect to such action
no default or event of default would exist under its note purchase agreement and
(b) immediately after giving effect to such action, it would be permitted to
incur an additional dollar of indebtedness under the debt incurrence test. It is
unlikely, however, that UNS Gas will pay dividends in the next five years due to
expected cash requirements for capital expenditures.
UNS ELECTRIC
RESULTS OF OPERATIONS
---------------------
In its first full year of operations, UNS Electric's net income for 2004
was approximately $4 million. Similar to TEP's operations, we expect UNS
Electric's operations to be seasonal in nature, with peak energy demand
occurring in the summer months.
As of December 31, 2004, UNS Electric had approximately 85,500 retail
customers, a 5% increase from last year. The table below shows UNS Electric's
kWh sales and revenues for 2004 and 2003. Results in 2003 are for the period
August 11 to December 31.
K-52
SALES REVENUE
2004 2003* 2004 2003*
--------------------------------------------------------------------------------
- Millions of kWh - - Millions of Dollars -
ELECTRIC RETAIL SALES:
Residential 692 302 $ 70 $ 30
Commercial 574 153 58 16
Industrial 194 59 14 4
Other 3 47 1 5
------------------------------------------------------------------------------
TOTAL ELECTRIC RETAIL SALES 1,463 561 $143 $ 55
==============================================================================
*For the period August 11 to December 31, 2003
The table below provides summary financial information for UNS Electric.
2004 2003*
---------------------------------------------------------------------
-Millions of Dollars-
Electric Revenues $ 143 $ 55
Other Revenues 1 1
---------------------------------------------------------------------
Total Operating Revenues 144 56
Purchased Energy Expense 96 39
---------------------------------------------------------------------
Utility Gross Margin 48 17
---------------------------------------------------------------------
Other Operations and Maintenance Expense 24 6
Depreciation and Amortization 9 3
Taxes other than Income Taxes 3 3
---------------------------------------------------------------------
Total Other Operating Expenses 36 12
---------------------------------------------------------------------
Operating Income 12 5
---------------------------------------------------------------------
Total Interest Expense 5 2
Income Tax Expense 3 1
---------------------------------------------------------------------
NET INCOME $ 4 $ 2
=====================================================================
*For the period August 11 to December 31, 2003
FACTORS AFFECTING RESULTS OF OPERATONS
--------------------------------------
COMPETITION
As required by the ACC order approving UniSource Energy's acquisition of
the Citizens' Arizona gas and electric assets, on November 3, 2003, UNS Electric
filed with the ACC a plan to open its service territories to retail competition
by December 31, 2003. The plan addresses all aspects of implementation. It
includes UNS Electric's unbundled distribution tariffs for both standard offer
customers and customers that choose competitive retail access, as well as Direct
Access and Settlement Fee schedules. UNS Electric direct access rates for both
transmission and ancillary services will be based upon its FERC Open Access
Transmission Tariff. The plan is subject to review and approval by the ACC. As a
result of the court decisions concerning the ACC's Retail Electric Competition
Rules, we are unable to predict when and how the ACC will address this plan. See
Tucson Electric Power Company, Factors Affecting Results of Operations,
Competition, above for information regarding the recent Arizona Court of Appeals
decision.
RATES AND REGULATION
ACC ORDER ON CITIZENS' ASSET ACQUISITION
On July 3, 2003, the ACC issued an order approving the acquisition of
Citizens' Arizona electric assets. Concurrent with the closing of the
acquisition, retail rate increases for customers of UNS Electric went into
effect on August 11, 2003. Key provisions of the order include:
o 22% overall increase in retail rates through its Purchased Power Fuel
Adjustor Clause (PPFAC).
o UNS Electric must file a plan with the ACC to open its service
territories to retail competition by no later than December 31, 2003
(which was filed by UNS Electric on November 3, 2003).
K-53
o Restricts the filing of a general rate case until August 2006 and any
resulting rate increase shall not become effective prior to August 1,
2007.
o Limits dividends payable by UNS Electric to UniSource Energy to 75% of
earnings until the ratio of common equity to total capitalization
reaches 40%.
o Requires UNS Electric to enter into negotiations with Pinnacle West
Capital Corporation (PWCC) to seek to reduce the cost of its purchased
power contract with PWCC.
ENERGY COST ADJUSTMENT MECHANISMS
UNS Electric's retail rates include a PPFAC, which allows for a separate
surcharge or surcredit to the base rate for delivered purchased power to collect
or return under or over recovery of costs. As part of the July 3, 2003 ACC
Order, a new PPFAC surcharge of $0.01825 per kWh was approved to fully recover
the cost of the current full-requirements power supply agreement with PWCC. UNS
Electric is required to enter into negotiations with PWCC to potentially reduce
the cost of this purchased power contract; 90% of any savings from the
negotiations is to be passed on to UNS Electric rate payers.
LIQUIDITY AND CAPITAL RESOURCES
-------------------------------
UNS Electric's capital requirements consist primarily of capital
expenditures. In 2004, capital expenditures were approximately $19 million.
During 2005, UNS Electric expects to generate sufficient internal cash flows to
fund its operating activities and a portion of its construction expenditures.
Remaining cash needed for construction expenditures is expected to be obtained
through a combination of additional equity investments from UniSource Energy and
borrowings under a revolving credit facility that UES expects to establish.
On March 10, 2005, UniSource Energy contributed an additional $4 million in
equity to UNS Electric.
The table below provides summary information for operating cash flow and
capital expenditures for 2004 and 2003.
2004 2003*
-----------------------------------------------------------------------
-Millions of Dollars-
Net Cash Flows - Operating Activities $ 19 $ 8
Capital Expenditures 19 5
-----------------------------------------------------------------------
*For the period August 11 to December 31, 2003
Forecasted capital expenditures for UNS Electric are as follows:
2005 2006 2007 2008 2009
- Millions of Dollars -
--------------------------------------------------------------------------------
UNS Electric $ 26 $ 30 $ 26 $ 26 $ 27
--------------------------------------------------------------------------------
Senior Unsecured Notes
----------------------
On August 11, 2003, UNS Electric issued $60 million of aggregate principal
amount of 7.61% senior unsecured notes due in 2008 in a private placement.
Proceeds from the note issuance were paid to Citizens to purchase the Arizona
electric system assets. The notes are guaranteed by UES.
The note purchase agreements for UNS Electric contain certain restrictive
covenants, including restrictions on transactions with affiliates, mergers,
liens to secure indebtedness, restricted payments, incurrence of indebtedness,
and minimum net worth. Consolidated Net Worth, as defined by the note purchase
agreements for UNS Electric, is approximately equal to the balance sheet line
item, Common Stock Equity. The table below outlines the actual and required
minimum net worth levels of UES and UNS Electric at December 31, 2004.
COMPANY REQUIRED NET WORTH ACTUAL NET WORTH
---------------------------------------------------------------------
- Millions of Dollars -
UES $ 50 $ 100
UNS Electric 26 41
---------------------------------------------------------------------
The incurrence of indebtedness covenant requires UNS Electric to meet
certain tests before additional indebtedness may be incurred. These tests
include:
K-54
o A ratio of Consolidated Long-Term Debt to Consolidated Total
Capitalization of no greater than 0.65 to 1.00.
o An Interest Coverage Ratio (a measure of cash flow to cover interest
expense) of at least 2.50 to 1.00.
However, UNS Electric may, without meeting these tests, refinance
indebtedness and incur short-term debt in an amount not to exceed $5 million.
UNS Electric may not declare or make distributions or dividends (restricted
payments) on its common stock unless (a) immediately after giving effect to such
action no default or event of default would exist under its note purchase
agreement and (b) immediately after giving effect to such action, it would be
permitted to incur an additional dollar of indebtedness under the debt
incurrence test. As of December 31, 2004, UNS Electric was in compliance with
the terms of the note purchase agreement.
The senior unsecured notes may be accelerated upon the occurrence and
continuance of an event of default under the note purchase agreement. Events of
default under the note purchase agreement include failure to make payments
required thereunder, certain events of bankruptcy or commencement of similar
liquidation or reorganization proceedings or a change of control of UES or UNS
Electric. In addition, an event of default may occur if UNS Electric, UES or UNS
Gas defaults on any payments required in respect of certain indebtedness that is
outstanding in an aggregate principal amount of at least $4 million or if any
such indebtedness becomes due or capable of being called for payment prior to
its scheduled payment date or if there is a default in the performance or
compliance with the other terms of such indebtedness and, as a result of such
default, such indebtedness has become, or has been declared, due and payable,
prior to its scheduled payment date.
CONTRACTUAL OBLIGATIONS
UNS ELECTRIC POWER SUPPLY AND TRANSMISSION CONTRACTS
UNS Electric has a full requirements power supply agreement with PWCC. The
agreement expires May 31, 2008. The agreement obligates PWCC to supply all of
UNS Electric's power requirements at a fixed price per MWh. Payments under the
contract are usage based, with no fixed customer or demand charges. UNS Electric
is currently evaluating potential replacement energy resources when its supply
contract ends with PWCC in 2008.
UNS Electric imports the power it purchases over the Western Area Power
Administration's (WAPA) transmission lines. UNS Electric's transmission capacity
agreements with WAPA provide for annual rate adjustments and expire in February
2008 and June 2011. The contract that expires in 2008 also contains a capacity
adjustment clause. Under the terms of the agreements, UNS Electric's aggregated
minimum fixed transmission charges are expected to be $1 million in 2005 through
2011. UNS Electric made payments under these contracts of $6 million in 2004 and
$2 million in 2003.
DIVIDENDS ON COMMON STOCK
The Citizens Settlement Agreement, as approved by the ACC, limits dividends
payable by UNS Electric to 75% of earnings until the ratio of common equity to
total capitalization reaches 40%. At December 31, 2004, the ratio of common
equity to total capitalization for UNS Electric was 40%.
A $4 million equity investment from UniSource Energy on March 10, 2005
increased UNS Electric's ratio of common equity to total capitalization to more
than 40%.
The note purchase agreement for UNS Electric contains restrictive covenants
including restrictions on dividends. According to the note purchase agreements
UNS Electric may not declare or make distributions or dividends (restricted
payments) on its common stock unless, (a) immediately after giving effect to
such action no default or event of default would exist under its note purchase
agreement and (b) immediately after giving effect to such action, it would be
permitted to incur an additional dollar of indebtedness under the debt
incurrence test.
GLOBAL SOLAR ENERGY, INC.
RESULTS OF OPERATIONS
---------------------
UniSource Energy accounts for Global Solar under the consolidation method
and recognizes 100% of Global Solar's losses. Global Solar recognizes expense
when funding is used for research, development and administrative costs.
Millennium made no contributions to Global Solar during 2004. However, UniSource
Energy provided $7 million to Global Solar under a tax sharing agreement.
K-55
Millennium has been authorized to fund up to an additional $5 million for
capital expenditures and operations at Global Solar.
The table below provides a breakdown of the net losses recorded by Global
Solar for the last three years.
2004 2003 2002
----------------------------------------------------------------------------------------------------------
- Millions of Dollars -
Global Solar
Research & Development Contract Revenues from Third Parties $ 1 $ 1 $ 1
Other Revenues 8 9 7
Research & Development Contract Expenses & Losses (4) (5) (4)
Research & Development - Internal Development Expenses - (1) (2)
Depreciation & Amortization Expense (3) (3) (3)
Administrative & Other Costs (11) (13) (14)
Income Tax Benefits 4 5 1
----------------------------------------------------------------------------------------------------------
Total Global Solar Net Loss $ (5) $ (7) $ (14)
==========================================================================================================
GLOBAL SOLAR COMMITMENTS
It is our intention for UniSource Energy to cease additional funding of
Global Solar. To that end, Millennium plans to seek additional investors for
Global Solar, or sell all or part of its interest, or a combination of both, to
preserve the value of Global Solar. We anticipate that any operating and capital
funding required to maintain Global Solar in the interim will be provided only
out of existing Millennium cash or cash returns from Millennium investments. We
believe such cash and returns will be adequate for that purpose and to fund
Millennium's remaining commitments to Global Solar. Millennium has been
authorized to fund up to an additional $5 million for capital expenditures and
operations at Global Solar. Global Solar has $1 million in commitments to incur
future expenses related to government contracts.
OTHER
RESULTS OF OPERATIONS
---------------------
The Other segment consists of: UniSource Energy parent company expenses;
income and losses from other Millennium investments; and income and losses from
UED. UniSource Energy parent company expenses include: interest expense (net of
tax) on the note payable from UniSource Energy to TEP and costs in 2003
associated with the Citizens acquisition.
The table below summarizes the income and losses for the Other segment in
the last three years.
2004 2003 2002
-----------------------------------------------------------------------------
- Millions of Dollars -
Other Millennium Investments $ 1 $ (9) $ (2)
UED (1) 7 1
UniSource Energy Parent Company (5) (9) (5)
-----------------------------------------------------------------------------
Total Other $ (5) $ (11) $ (6)
=============================================================================
OTHER MILLENNIUM INVESTMENTS
Millennium accounts for its investments under the consolidation method and
the equity method. In some cases, Millennium is an investment's sole provider of
funding. When this is the case, Millennium recognizes 100% of an investment's
losses, because as sole provider of funds it bears all of the financial risk. To
the extent that an investment becomes profitable and Millennium has recognized
losses in excess of its percentage ownership, Millennium will recognize 100% of
an investment's net income until Millennium's recognized losses equal its
ownership percentage of losses.
Results from Other Millennium Investments in 2004 include after-tax gains
of $3 million from Haddington, $2 million from MicroSat and less than $1 million
from SES. The gains were partially offset by after-tax losses of $2 million from
K-56
IPS and less than $1 million each from MEG, Nations Energy and POWERTRUSION
International, Inc. (Powertrusion), a manufacturer of lightweight utility poles.
Results from Other Millennium Investments in 2003 include after-tax losses
of $2 million each from IPS and Powertrusion, $1 million from MicroSat, and less
than $1 million each from MEG, SES, Nations Energy and TruePricing, Inc.
(TruePricing).
Results from Other Millennium Investments in 2002 include after-tax losses
of $3 million from IPS, $2 million from Powertrusion and less than $1 million
each from TruePricing, MEG and SES. These losses were partially offset by income
tax benefits recorded by Advanced Energy Technologies, the holding company that
holds Millennium's investments in Global Solar and IPS.
CONSOLIDATED MILLENNIUM INVESTMENTS
Millennium funded $1.5 million in debt commitments to IPS during 2004, and
Dow Corning Enterprises, Inc. (DCEI) also funded its $1 million commitment.
Pursuant to the terms of amended promissory notes with IPS, Millennium and DCEI
have the right to convert at any time the outstanding debt amounts to equity
ownership. DCEI holds warrants to purchase additional preferred shares of IPS
that if exercised, could result in Millennium's ownership of IPS being reduced
to as low as 59%. Millennium has been authorized to fund up to an additional
$3.3 million for capital and operations at IPS. Millennium and DCEI are
continuing to evaluate the ongoing viability of IPS. In the event the operations
of IPS are discontinued, Millennium would recognize an after-tax loss of less
than $1 million.
MEG is in the process of winding down its activities and will not engage in
any new activities after 2005. As of January 31, 2005, the fair value of MEG's
trading assets was $62 million and the fair value of MEG's trading liabilities
was $56 million.
Through subsidiaries, Nations Energy has a 32% interest in a 43 MW power
plant in Panama. Although Nations Energy still intends to sell its interest in
this plant, the $0.8 million book value of the investment was written off in
2004 because attempts to sell the asset to date have been unsuccessful.
EQUITY METHOD MILLENNIUM INVESTMENTS
In 2004, Haddington sold one of its investments and recognized the related
gain as income. Millennium's pre-tax share of the gain was $5 million and
Millennium received a $7 million distribution from Haddington related to the
sale. Haddington also wrote down another of its investments and recognized the
related loss. Millennium's pre-tax share of the loss was $2 million. Millennium
recorded its share of Haddington's income and loss during 2004, which includes
Haddington's gains and losses on investments.
Millennium's after-tax gains from MicroSat in 2004 resulted primarily from
the settlement of a cost share agreement under a government contract and an
overhead billing rate adjustment. Millennium made no contributions to MicroSat
during 2004 and has no further funding commitments to MicroSat. As sole funder,
Millennium recognizes 100% of MicroSat's net income/losses.
As technology developers, Global Solar, IPS and MicroSat face many
challenges, such as developing technologies that can be manufactured on an
economic scale, technological obsolescence, competition and possible reductions
in government spending to advance technological research and development
activities.
MILLENNIUM COMMITMENTS
It is our intention for UniSource Energy to cease making capital
contributions to Millennium. To that end, Millennium has eliminated its
investment in TruePricing and significantly reduced the holdings and activities
of MEG. Millennium is also in the process of selling its remaining interest in
Nations Energy. Millennium plans to seek additional investors for Global Solar
and IPS, or sell all or part of its interest in those entities, or a combination
of both, to preserve the value of the investments. We anticipate that any
operating and capital funding required to maintain Global Solar or IPS in the
interim will be provided only out of existing Millennium cash or cash returns
from Millennium investments. We believe such cash and returns will be adequate
for that purpose and to fund Millennium's remaining commitments. To date,
Millennium has been authorized to fund up to an additional $5 million for
capital expenditures and operations at Global Solar, and up to $3.3 million for
capital and operations at IPS. Millennium's remaining commitments for other
Millennium investments are $4 million to Haddington and $3 million to Valley
Ventures.
K-57
UNISOURCE ENERGY DEVELOPMENT
In June 2004, UED recognized an impairment loss on its note receivable from
an independent power producer. As UED's recovery of the note receivable from the
entity is subordinated to the rights of others, UED wrote off the entire $2
million balance due on the note at the time that Haddington, an investor in the
independent power producer, determined that its investment was impaired. In
2004, UED's net loss was $1 million.
UED recorded net income of $7 million in 2003 compared with $1 million in
2002. UED's income in 2003 primarily represents an $11 million pre-tax
development fee received at the financial closing of the Springerville Unit 3
Project.
UED's net income in 2002 represented rental income (less expenses) under an
operating lease of the 20 MW North Loop turbine to TEP. The rental income was
eliminated from UniSource Energy's consolidated after-tax earnings as an
inter-company transaction. TEP purchased the turbine from UED in September 2002.
On October 21, 2003, Tri-State completed financing of Unit 3 and began
construction. UED received reimbursement of its development costs totaling $29
million, as well as an $11 million development fee. On October 24, 2003,
UniSource Energy used the proceeds to repay a $35 million short-term bridge
loan.
TEP will manage the development of Unit 3. Upon the completion of
construction in the third quarter of 2006, TEP expects to receive annual pre-tax
benefits of approximately $15 million in the form of cost savings, rental
payments, transmission revenues, and other fees. TEP will also benefit from
upgraded emissions controls for Units 1 and 2, totaling approximately $90
million, which will be paid for by the Unit 3 project.
UED has no significant current operations.
CRITICAL ACCOUNTING ESTIMATES
-----------------------------
In preparing financial statements under Generally Accepted Accounting
Principles (GAAP), management exercises judgment in the selection and
application of accounting principles, including making estimates and
assumptions. UniSource Energy and TEP consider Critical Accounting Estimates to
be those that could result in materially different financial statement results
if our assumptions regarding application of accounting principles were
different. UniSource Energy and TEP describe their Critical Accounting Estimates
below. Other significant accounting policies and recently issued accounting
standards are discussed in Note 1 of Notes to Consolidated Financial Statements
- Nature of Operations and Summary of Significant Accounting Estimates.
ACCOUNTING FOR RATE REGULATION
TEP, UNS Gas and UNS Electric generally use the same accounting policies
and practices used by unregulated companies for financial reporting under GAAP.
However, sometimes these principles, such as the Financial Accounting Standards
Board's (FASB) Statement of Financial Accounting Standards No. 71, Accounting
for the Effects of Certain Types of Regulation (FAS 71), require special
accounting treatment for regulated companies to show the effect of regulation.
For example, in setting TEP, UNS Gas and UNS Electric's retail rates, the ACC
may not allow TEP, UNS Gas or UNS Electric to currently charge their customers
to recover certain expenses, but instead may require that these expenses be
charged to customers in the future. In this situation, FAS 71 requires that TEP,
UNS Gas and UNS Electric defer these items and show them as regulatory assets on
the balance sheet until TEP, UNS Gas and UNS Electric are allowed to charge
their customers. TEP, UNS Gas and UNS Electric then amortize these items as
expense to the income statement as these charges are recovered from customers.
Similarly, certain revenue items may be deferred as regulatory liabilities,
which are also eventually amortized to the income statement as rates to
customers are reduced.
The conditions a regulated company must satisfy to apply the accounting
policies and practices of FAS 71 include:
o an independent regulator sets rates;
o the regulator sets the rates to recover specific costs of delivering
service; and
o the service territory lacks competitive pressures to reduce rates
below the rates set by the regulator.
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TEP
In November 1999, upon approval by the ACC of the TEP Settlement Agreement
relating to recovery of TEP's transition costs and standard retail rates, TEP
discontinued application of FAS 71 to its generation operations. TEP's
transmission and distribution regulatory assets, net of regulatory liabilities,
totaled $225 million at December 31, 2004, $23 million of which is not presently
included in the rate base and consequently is not earning a return on
investment.
TEP continues to apply FAS 71 to its regulated operations, which include
the transmission and distribution portions of its business. TEP regularly
assesses whether it can continue to apply FAS 71 to these operations. If TEP
stopped applying FAS 71 to its remaining regulated operations, it would write
off the related balances of its regulatory assets as an expense and its
regulatory liabilities as income on its income statement. Based on the
regulatory asset balances, net of regulatory liabilities, at December 31, 2004,
if TEP had stopped applying FAS 71 to its remaining regulated operations, it
would have recorded an extraordinary after-tax loss of approximately $136
million. While regulatory orders and market conditions may affect cash flows,
TEP's cash flows would not be affected if it stopped applying FAS 71 unless a
regulatory order limited its ability to recover the cost of its regulatory
assets.
UNS GAS AND UNS ELECTRIC
UNS Gas and UNS Electric's regulatory liabilities, net of regulatory
assets, collectively totaled $4 million at December 31, 2004. UNS Gas and UNS
Electric's regulatory assets and liabilities are included in rate base and
consequently are earning a return on investment. If UNS Gas and UNS Electric
stopped applying FAS 71 to their regulated operations, they would write off the
related balances of regulatory assets as an expense and regulatory liabilities
as income on their income statements. Based on the balances of regulatory
liabilities and assets at December 31, 2004, if UNS Gas and UNS Electric had
stopped applying FAS 71 to their regulated operations, they would have
collectively recorded an extraordinary after-tax gain of $2 million. UNS Gas and
UNS Electric's cash flows would not be affected if they stopped applying FAS 71
unless a regulatory order limited their ability to recover the cost of their
regulatory assets.
ACCOUNTING FOR ASSET RETIREMENT OBLIGATIONS
FAS 143, issued by the FASB in June 2001, requires entities to record the
fair value of a liability for a legal obligation to retire an asset in the
period in which the liability is incurred. A legal obligation is a liability
that a party is required to settle as a result of an existing or enacted law,
statute, ordinance or contract. When the liability is initially recorded, the
entity should capitalize a cost by increasing the carrying amount of the related
long-lived asset. Over time, the liability is adjusted to its present value by
recognizing accretion expense as an operating expense in the income statement
each period, and the capitalized cost is depreciated over the useful life of the
related asset. Upon settlement of the liability, an entity either settles the
obligation for its recorded amount or incurs a gain or loss if the actual costs
differ from the recorded amount.
TEP
Prior to adopting FAS 143, costs for final removal of all owned generation
facilities were accrued as an additional component of depreciation expense.
Under FAS 143, only the costs to remove an asset with legally binding retirement
obligations will be accrued over time through accretion of the asset retirement
obligation and depreciation of the capitalized asset retirement cost.
TEP has identified legal obligations to retire generation plant assets
specified in land leases for its jointly-owned Navajo and Four Corners
Generating Stations. The land on which these stations reside is leased from the
Navajo Nation. The provisions of the leases require the lessees to remove the
facilities upon request of the Navajo Nation at the expiration of the leases.
TEP also has certain environmental obligations at the San Juan Generating
Station. TEP has estimated that its share of the cost to remove the Navajo and
Four Corners facilities and settle the San Juan environmental obligations will
be approximately $38 million at the date of retirement. No other legal
obligations to retire generation plant assets were identified. As of December
31, 2002, TEP had accrued $113 million for the final decommissioning of its
generating facilities. As discussed below, this amount was reversed for 2002 and
included as part of the cumulative effect of accounting change adjustment when
FAS 143 was adopted on January 1, 2003.
On November 12, 2004, TEP, Phelps Dodge Energy Services, LLC and PNM
Resources, Inc. each purchased from Duke Energy North America, LLC a one-third
interest in a limited liability company which owns the partially constructed
natural gas-fired Luna Energy Facility (Luna) in southern New Mexico. Luna is
designed as a 570-MW combined cycle plant and is expected to be operational by
the summer of 2006. See Item 1. - Future Generating Resources - TEP. The new
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owners assumed asset retirement obligations to remove certain piping and
evaporation ponds and to restore the ground to its original condition. TEP has
estimated its share to settle the obligations will be approximately $2 million
at the date of retirement.
TEP has various transmission and distribution lines that operate under land
leases and rights of way that contain end dates and restorative clauses. TEP
operates its transmission and distribution lines as if they will be operated in
perpetuity and would continue to be used or sold without land remediation. As a
result, TEP is not recognizing the costs of final removal of the transmission
and distribution lines in the financial statements. As of December 31, 2004, TEP
had accrued $67 million for the net cost of removal for the interim retirements
from its transmission, distribution and general plant. As of December 31, 2003,
TEP had accrued $60 million for these removal costs. The amount is recorded as a
regulatory liability.
Upon adoption of FAS 143 on January 1, 2003, TEP recorded an asset
retirement obligation of $38 million at its net present value of $1 million,
increased depreciable assets by $0.1 million for asset retirement costs,
reversed $113 million of costs previously accrued for final removal from
accumulated depreciation, reversed previously recorded deferred tax assets by
$44 million and recognized the cumulative effect of accounting change as a gain
of $112 million ($67 million net of tax). Adopting FAS 143 has resulted in a
reduction to current depreciation expense charged throughout the year as well
because asset retirement costs are no longer recorded as a component of
depreciation expense. For the year ended December 31, 2003 and succeeding years,
the annual reduction in depreciation expense is approximately $6 million.
Amounts recorded under FAS 143 are subject to various assumptions and
determinations, such as determining whether a legal obligation exists to remove
assets, estimating the fair value of the costs of removal, estimating when final
removal will occur, and the credit-adjusted risk-free interest rates to be used
to discount future liabilities. Changes that may arise over time with regard to
these assumptions and determinations will change amounts recorded in the future
as expense for asset retirement obligations.
If TEP retires any asset at the end of its useful life, without a legal
obligation to do so, it will record retirement costs at that time as incurred or
accrued. TEP does not believe that the adoption of FAS 143 will result in any
change in retail rates since all matters relating to the rate-making treatment
of TEP's generating assets have been determined pursuant to the TEP Settlement
Agreement.
UES
UES has various transmission and distribution lines that operate under land
leases and rights of way that contain end dates and restorative clauses. UES
operates its transmission and distribution lines as if they will be operated in
perpetuity and would continue to be used or sold without land remediation. As a
result, UES is not recognizing the cost of final removal of the transmission and
distribution lines in the financial statements. As of December 31, 2004, UES had
accrued $2 million and as of December 31, 2003, UES had accrued $0.6 million for
the net cost of removal for interim retirements from its transmission,
distribution and general plant. The amount is recorded as a regulatory
liability.
PENSION AND OTHER POST RETIREMENT BENEFIT PLAN ASSUMPTIONS
We record plan assets, obligations, and expenses related to pension and
other postretirement benefit plans based on actuarial valuations. These
valuations include key assumptions on discount rates, expected returns on plan
assets, compensation increases and health care cost trend rates. These actuarial
assumptions are reviewed annually and modified as appropriate. The effect of
modifications is generally recorded or amortized over future periods. We believe
that the assumptions used in recording obligations under the plans are
reasonable based on prior experience, market conditions and the advice of plan
actuaries.
TEP
TEP discounted its future pension plan obligations at December 31, 2004
using rates of 6.1% for its Salaried and Union Plans and 6.0% for its Excess
Benefit Plan. The discount rate used at December 31, 2003 was 6.25% for all
plans. TEP discounted its other postretirement plan obligations using a rate of
5.9% at December 31, 2004, compared with 5.5% at December 31, 2003. TEP
determines the discount rate annually based on the rates currently available on
high-quality, long-term bonds. TEP looks to bonds that receive one of the two
highest ratings given by a recognized rating agency whose future cash flows
match the timing and amount of expected future benefit payments.
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The pension liability and future pension expense both increase as the
discount rate is reduced. A decrease in the discount rate results in an increase
in the Projected Benefit Obligation (PBO) and the service cost component of
pension expense. Additionally, the recognized actuarial loss is significantly
impacted by a reduction in the discount rate. Since the PBO increases with the
decrease in discount rate, the obligation is that much larger than would
normally occur due to normal growth of the plan. This leads to an actuarial loss
(or a greater actuarial loss than would occur in the absence of the discount
rate change), which is amortized over future periods leading to a greater
expense. The resulting change in the interest cost component of pension expense
is dependent on the effect that the change in the discount rate has on the PBO
and will vary based on employee demographics. The effect of the lower rate used
to calculate the interest cost is offset to some degree by a larger obligation.
The relative magnitude of these two changes determines whether interest cost
will increase or decrease. For TEP's pension plans, a 25 basis point decrease in
the discount rate would increase the accumulated benefit obligation (ABO) by
approximately $5 million and the related plan expense for 2005 by approximately
$1 million. A similar increase in the discount rate would decrease the ABO by
approximately $5 million and the related plan expense for 2005 by approximately
$1 million. For TEP's plan for other postretirement benefits, a 25 basis point
change in the discount rate would increase or decrease the accumulated
postretirement benefit obligation (APBO) by approximately $2 million. A 25 basis
point change in the discount rate would not have a significant impact on the
related plan expense for 2005.
TEP calculates the market-related value of plan assets using the fair value
of plan assets on the measurement date. TEP assumed that its plans' assets would
generate a long-term rate of return of 8.5% at December 31, 2004 and 8.75% at
December 31, 2003. In establishing its assumption as to the expected return on
plan assets, TEP reviews the plans' asset allocation and develops return
assumptions for each asset class based on advice from an investment consultant
and the plans' actuary that includes both historical performance analysis and
forward looking views of the financial markets. Pension expense increases as the
expected rate of return on plan assets decreases. A 25 basis point change in the
expected return on plan assets would not have a significant impact on pension
expense for 2005.
TEP used an initial health care cost trend rate of 11.0% in valuing its
postretirement benefit obligation at December 31, 2004. This rate reflects both
market conditions and the plan's experience. Assumed health care cost trend
rates have a significant effect on the amounts reported for health care plans. A
1% increase in assumed health care cost trend rates would increase the
postretirement benefit obligation by approximately $5 million and the related
plan expense by approximately $1 million. A similar decrease in assumed health
care cost trend rates would decrease the postretirement benefit obligation by
approximately $4 million and the related plan expense by less than $1 million.
TEP recorded a minimum pension liability in Other Comprehensive Income of
approximately $20 million at December 31, 2004, compared with $3 million at
December 31, 2003. This increase resulted primarily from changes in actuarial
assumptions including revised retirements rates, updated mortality rates and a
reduction in the assumed discount rate.
Based on the above assumptions, TEP will record pension expense of
approximately $10 million and other postretirement benefit expense of $7 million
ratably throughout 2005. TEP will make required pension plan contributions of $6
million in 2005. TEP's other postretirement benefit plan is not funded. TEP
expects to make benefit payments to retirees under the postretirement benefit
plan of approximately $3 million in 2005.
UES
Concurrent with the acquisition of the Arizona gas and electric system
assets from Citizens on August 11, 2003, UES established a pension plan for
substantially all of its employees. UES did not assume the pension obligation
for employees' years of service with Citizens.
UES discounted its future pension plan obligations using a rate of 6.1% at
December 31, 2004 and 6.25% at December 31, 2003. For UES' pension plan, a 25
basis point change in the discount rate would have minimal effect on either the
ABO or the related pension expense. UES recorded a minimum pension liability and
an offsetting Intangible Asset of less than $1 million at December 31, 2004 and
approximately $1 million at December 31, 2003. UES will record pension expense
of $1 million in 2005. UES will make a pension plan contribution of $1 million
in 2005.
On the acquisition date, UES assumed the obligation to provide
postretirement benefits for a small population of former Citizens employees,
both active and retired. The plan is not funded. UES discounted its other
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postretirement plan obligations using a rate of 5.9% at December 31, 2004,
compared with 5.5% at December 31, 2003. Postretirement medical benefit expenses
are insignificant to UES' operations.
ACCOUNTING FOR DERIVATIVE INSTRUMENTS, TRADING ACTIVITIES AND HEDGING
ACTIVITIES
A derivative financial instrument or other contract derives its value from
another investment or designated benchmark. TEP enters into forward contracts to
purchase or sell a specified amount of capacity or energy at a specified price
over a given period of time, typically for one month, three months, or one year,
within established limits to take advantage of favorable market opportunities.
In general, TEP enters into forward purchase contracts when market conditions
provide the opportunity to purchase energy for its load at prices that are below
the marginal cost of its supply resources or to supplement its own resources
(e.g., during plant outages and summer peaking periods). TEP enters into forward
sales contracts when it forecasts that it has excess supply and the market price
of energy exceeds its marginal cost. The majority of TEP's forward contracts are
considered to be normal purchases and sales and, therefore, are not required to
be marked to market. However, some of these forward contracts are considered to
be derivatives, which TEP marks to market by recording unrealized gains and
losses and adjusting the related assets and liabilities on a monthly basis to
reflect the market prices at the end of the month.
TEP has a natural gas supply agreement under which it purchases all of its
gas requirements at spot market prices from Southwest Gas Corporation (SWG). TEP
also has agreements to purchase power that are priced using spot market gas
prices. These contracts meet the definition of normal purchases and are not
required to be marked to market. During 2004 and early 2005, in an effort to
minimize price risk on these purchases, TEP entered into commodity price swap
agreements under which TEP purchases gas at fixed prices and simultaneously
sells gas at spot market prices. The spot market price in the swap agreements is
tied to the same index as the purchases under the SWG and purchased power
contracts. These swap agreements, which expire during the summer months through
2007, were entered into with the goal of locking in fixed prices on at least 45%
and not more than 80% of TEP's expected summer monthly gas risk prior to
entering into the month. The swap agreements are marked to market on a monthly
basis; however, since the agreements satisfy the requirements for cash flow
hedge accounting, the unrealized gains and losses are recorded in Other
Comprehensive Income, a component of Common Stock Equity, rather than being
reflected in the income statement. As the gains and losses on these cash flow
hedges are realized, a reclassification adjustment is recorded in Other
Comprehensive Income for realized gains and losses that are included in Net
Income.
TEP manages the risk of counterparty default by performing financial credit
reviews, setting limits, monitoring exposures, requiring collateral when needed,
and using a standardized agreement which allows for the netting of current
period exposures to and from a single counterparty.
UNS Gas and UNS Electric do not currently have any contracts that are
required to be marked to market. UNS Gas does have a natural gas supply and
management agreement under which it purchases substantially all of its gas
requirements at market prices from BP Energy Company (BP). However, the contract
terms allow UNS Gas to lock in fixed prices on a portion of its gas purchases by
entering into fixed price forward contracts with BP at various times during the
year. This enables UNS Gas to provide more stable prices to its customers. These
purchases are made up to three years in advance with the goal of locking in
fixed prices on at least 45% and not more than 80% of the expected monthly gas
consumption prior to entering into the month. These forward contracts, as well
as the main gas supply contract, meet the definition of normal purchases and
therefore are not required to be marked to market.
MEG, a wholly-owned subsidiary of Millennium, enters into swap agreements,
options and forward contracts relating to Emissions Allowances and coal. MEG
marks its trading contracts to market by recording unrealized gains and losses
and adjusting the related assets and liabilities on a monthly basis to reflect
the market prices at the end of the month. In accordance with UniSource Energy's
intention to cease making capital contributions to Millennium, Millennium has
significantly reduced the holdings and activity of MEG. MEG is in the process of
winding down its activities and will not engage in any new activities after
2005.
The market prices used to determine fair values for TEP and MEG's
derivative instruments at December 31, 2004 are estimated based on various
factors including broker quotes, exchange prices, over the counter prices and
time value. For TEP's forward power contracts, a 10% decrease in market prices
would result in an increase in unrealized gains of less than $1 million, while a
10% increase in market prices would result in a decrease in unrealized gains of
less than $1 million. For TEP's gas swap agreements, a 10% decrease in market
prices would result in a $2 million decrease in unrealized gains reported in
Other Comprehensive Income, while a 10% increase in market prices would result
in a $2 million increase in unrealized gains reported in Other Comprehensive
Income. For MEG's remaining trading contracts, a 10% decrease in market prices
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would result in a decrease in unrealized gains of less than $1 million, while a
10% increase in market prices would result in an increase in unrealized gains of
less than $1 million.
Because of the complexity of derivatives, the FASB established a
Derivatives Implementation Group (DIG). To date, the DIG has issued more than
100 interpretations to provide guidance in applying Statement of Financial
Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging
Activities (FAS 133). As the DIG or the FASB continues to issue interpretations,
TEP, UNS Gas and UNS Electric may change the conclusions they have reached and,
as a result, the accounting treatment and financial statement impact could
change in the future.
See Market Risks - Commodity Price Risk in Item 7A.
UNBILLED REVENUE - TEP AND UES
TEP's, UNS Gas's and UNS Electric's retail revenues include an estimate of
MWhs/therms delivered but unbilled at the end of each period. Unbilled revenues
are dependent upon a number of factors that require management's judgment
including estimates of retail sales and customer usage patterns. The unbilled
revenue is estimated by comparing the estimated MWhs/therms delivered to the
MWhs/therms billed to TEP, UNS Gas and UNS Electric retail customers. The excess
of estimated MWhs/therms delivered over MWhs/therms billed is then allocated to
the retail customer classes based on estimated usage by each customer class.
TEP, UNS Gas and UNS Electric then record revenue for each customer class based
on the various bill rates for each customer class. Due to the seasonal
fluctuations of TEP's actual load, the unbilled revenue amount increases during
the spring and summer months and decreases during the fall and winter months.
The unbilled revenue amount for UNS Gas sales increases during the fall and
winter months and decreases during the spring and summer months, whereas, the
unbilled revenue amount for UNS Electric sales increases during the spring and
summer months and decreases during the fall and winter months.
PLANT ASSET DEPRECIABLE LIVES - TEP AND UES
We calculate depreciation expense based on our estimate of the useful lives
of our plant assets. The estimated useful lives, and resulting depreciation
rates used to calculate depreciation expense for the transmission and
distribution businesses of both UES and TEP have been approved by the ACC in
prior rate decisions. Depreciation rates for transmission and distribution
cannot be changed without ACC approval.
The estimated remaining useful lives of TEP's generating facilities are
based on management's best estimate of the economic life of the units. These
estimates are based on engineering estimates, economic analysis, and statistical
analysis of TEP's past experience in maintaining the stations. For 2004,
depreciation expense related to generation assets was $35 million, and our
generation assets are currently depreciated over periods ranging from 23 to 70
years from the original in-service dates.
During the first quarter of 2004, TEP engaged an independent third party to
review the economic estimated useful lives of its owned generating assets in
Springerville, Arizona. TEP then hired a different independent third party to
perform a depreciation study for its generation assets, taking into
consideration the newly determined economic useful life for the Springerville
assets, and changes in generation plant life information used by the operators
and other participants of the joint power plants in which TEP participates. As a
result of these analyses, TEP lengthened the useful lives of various generation
assets for periods ranging from 11 to 22 years in July 2004. Consequently,
depreciation rates and the corresponding depreciation expense have been revised
prospectively to reflect the life extensions. The annual impact of these changes
in depreciation rates is a reduction in depreciation expense of $9 million. A
study is currently underway by the operating agent of the San Juan Generating
Station to determine whether San Juan's economic useful life has changed from
previous estimates. If the economic life of San Juan is extended by ten years,
TEP's annual depreciation expense would decrease by an additional $4 million.
DEFERRED TAX VALUATION - TEP AND MILLENNIUM
We record deferred tax liabilities for amounts that will increase income
taxes on future tax returns. We record deferred tax assets for amounts that
could be used to reduce income taxes on future tax returns. We record a
valuation allowance, or reserve, for the deferred tax asset amount that we may
not be able to use on future tax returns. We estimate the valuation allowance
based on our interpretation of the tax rules, prior tax audits, tax planning
strategies, scheduled reversal of deferred tax liabilities, and projected future
taxable income.
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The valuation allowance of $8 million at December 31, 2004 and $7 million
at December 31, 2003, which reduces the Deferred Tax Asset balance, relates to
net operating loss and investment tax credit carryforward amounts. The increase
of $1 million reflects the expiration of unused investment tax credit.
Of the $8 million valuation allowance balance at December 31, 2004, $7
million relates to losses generated by the Millennium entities. In the future if
UniSource Energy and the Millennium entities determine that all or a portion of
the remaining amounts may be used on tax returns, then UniSource Energy and the
Millennium entities would reduce the valuation allowance and recognize a tax
benefit of up to $7 million. The main factor that could cause UniSource Energy
and the Millennium entities to recognize a tax benefit would be a change in
expected future taxable income. The remaining $1 million of valuation allowance
balance at December 31, 2004, relates to ITC carryforwards at TEP which may not
be utilized on tax returns prior to their expiration. If in the future UniSource
Energy and TEP determine that it is probable that TEP will not be able to use
all or a portion of additional investment tax credit carryforward amounts, then
UniSource Energy and TEP would record a valuation allowance and recognize tax
expense. The primary factor that could cause TEP to record a valuation allowance
would be a change in expected future taxable income.
As of December 31, 2004, UniSource Energy's deferred income tax assets
include $14 million related to unregulated investment losses of Millennium.
TEP's deferred income tax assets include $1 million related to unregulated
investment losses. These losses have not been reflected on UniSource Energy's
consolidated income tax returns. If UniSource Energy is unable to recognize such
losses through its consolidated income tax return in the foreseeable future,
UniSource Energy and TEP would be required to write off these deferred tax
assets. Millennium intends to restructure its ownership in one of these
investments, Infinite Power Solutions (IPS), in 2005. As a result of this
restructuring, UniSource Energy expects to liquidate IPS for tax purposes
resulting in a taxable loss that will be reflected on UniSource Energy's
consolidated income tax return. If this liquidation, or another action resulting
in the recognition of the loss for tax purposes, does not occur UniSource Energy
would be required to eliminate the deferred tax assets and recognize additional
tax expense of $6 million.
NEW ACCOUNTING PRONOUNCEMENTS
-----------------------------
The FASB recently issued the following Statements of Financial Accounting
Standards (FAS) and FASB Interpretations (FIN):
o FAS 123(R), Share Based Payment, issued December 2004, requires all
share-based payments to employees, including grants of employee stock
options, to be recognized in the financial statements based on their
fair values. FAS 123(R) is effective for financial periods beginning
July 1, 2005. However, management early adopted FAS 123(R) effective
January 1, 2005. The adoption of FAS 123(R) did not have a significant
impact on our financial statements because stock options issued under
UniSource Energy's Omnibus Plan vested upon the shareholder vote to
approve the proposed acquisition of UniSource Energy by Saguaro. In
addition, the Omnibus Plan expired in February 2004, and no new
options can be issued. See Note 2 and Note 17 of Notes to Consolidated
Financial Statements.
o FAS 153, Exchanges of Nonmonetary Assets, issued December 2004,
requires nonmonetary exchanges be accounted for at fair value,
recognizing any gains or losses, if their fair value is determinable
within reasonable limits and the transaction has commercial substance.
A nonmonetary exchange has commercial substance if future cash flows
of the entity are expected to change significantly as a result of the
exchange. FAS 153 is effective for nonmonetary asset exchange
transactions occurring in periods beginning July 1, 2005. The adoption
of FAS 153 is not expected to have a significant impact on our
financial statements.
o FASB Staff Position (FSP) FAS 109-1, Application of FASB Statement No.
109, Accounting for Income Taxes, to the Tax Deduction on Qualified
Production Activities Provided by the American Jobs Creation Act of
2004, issued in December 2004, provides guidance on the application of
FAS 109 to the provision within the American Jobs Creation Act of 2004
that provides a tax deduction, beginning in 2005, on qualified
production activities, including a company's electric generation
activities. Under FSP FAS 109-1, recognition of the tax deduction on
qualified production activities is ordinarily reported in the year it
is earned. We are evaluating the impact on our financial position and
results of operations from the adoption of FSP FAS 109-1.
o FAS 151, Inventory Costs, issued November 2004, is an amendment of
Accounting Research Bulletin (ARB) No. 43, Chapter 4, Inventory
Pricing. FAS 151 clarifies that abnormal amounts of idle facility
expense, freight, handling costs, and wasted materials (spoilage)
should be recognized as current-period charges. FAS 151 also requires
the allocation of fixed production overheads to inventory based on the
normal capacity of the production facilities. FAS 151 is effective for
inventory costs incurred beginning January 1, 2006. The adoption of
FAS 151 is not expected to have a significant impact on our financial
statements.
o FIN 46, Consolidation of Variable Interest Entities, was issued in
January 2003, and was subsequently revised in December 2003. The
guidance addresses when a company should include in its financial
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statements the assets and liabilities of another entity. The primary
objectives of FIN 46 are to provide guidance on the identification of
entities for which control is achieved through means other than
through voting rights (variable interest entities) and to determine
when and which business enterprises should consolidate the variable
interest entity (primary beneficiary). FIN 46 requires that both the
primary beneficiary and all other enterprises with a significant
variable interest make additional disclosures. For public companies,
the revised FIN 46 is effective for financial periods ending after
March 15, 2004. Early application is permissible. Companies that
implemented FIN 46 prior to its revision may continue to apply that
guidance until the implementation date of the revision. The adoption
of FIN 46 and revisions did not and are not expected to have a
significant impact on our financial statements.
In July 2004, the Emerging Issues Task Force (EITF) reached a consensus on
Issue No. 02-14, Whether an Investor Should Apply the Equity Method of
Accounting to Investments Other Than Common Stock (EITF 02-14). EITF 02-14
concludes that an investor that has the ability to exercise significant
influence over the operating and financial policies of an investee should apply
the equity method of accounting only when it has an investment in common stock
or an investment that is in-substance common stock. EITF 02-14 is effective for
reporting periods beginning after September 15, 2004. The adoption of EITF 02-14
did not have a significant impact on our financial statements.
In June 2004, the EITF published Issue No. 03-1, The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain Investments (EITF
03-1). EITF 03-1 provides application guidance on impairment of securities
accounted for under FAS 115, Accounting for Certain Investments in Debt and
Equity Securities, and cost method investments and requires certain quantitative
and qualitative disclosures for securities that are impaired at the balance
sheet date but for which an other-than-temporary impairment has not been
recognized. The disclosure requirements are effective for reporting periods
ending after December 31, 2003. The FASB issued FSP EITF Issue 03-1-1, Effective
Date of Paragraphs 10-20 of EITF Issue No. 03-1, The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain Investments in
September 2004 delaying the effective date of the application guidance on
impairment of securities until the final issuance of FSP EITF Issue 03-1-a. The
adoption of EITF 03-1 is not expected to have a significant impact on our
financial statements.
In August 2003, the EITF published Issue No. 03-11, Reporting Realized
Gains and Losses on Derivative Instruments That Are Subject to FASB Statement
No. 133, Accounting for Derivative Instruments and Hedging Activities, and Not
"Held for Trading Purposes" as Defined in EITF Issue No. 02-3 (EITF 03-11). EITF
03-11 discusses whether realized gains and losses should be shown gross or net
in the income statement for contracts that are not held for trading purposes, as
defined in EITF 02-3, but are derivatives subject to FAS 133, Accounting for
Derivative Instruments and Hedging Activities. Determining whether realized
gains and losses on derivative contracts not held for trading purposes should be
reported in the income statement on a gross or net basis is a matter of judgment
that depends on the relevant facts and circumstances with respect to the various
activities of the entity. Retroactive application of EITF 03-11 is not required.
Beginning January 1, 2004, the realized gains and losses on derivative
instruments that are not held for trading purposes but are eventually net
settled are shown net in the income statement. The impact of adopting EITF 03-11
was immaterial as of December 31, 2004. See Note 7.
SAFE HARBOR FOR FORWARD-LOOKING STATEMENTS
------------------------------------------
This Annual Report on Form 10-K contains forward-looking statements as
defined by the Private Securities Litigation Reform Act of 1995. UniSource
Energy and TEP are including the following cautionary statements to make
applicable and take advantage of the safe harbor provisions of the Private
Securities Litigation Reform Act of 1995 for any forward-looking statements made
by or for UniSource Energy or TEP in this Annual Report on Form 10-K.
Forward-looking statements include statements concerning plans, objectives,
goals, strategies, future events or performance and underlying assumptions and
other statements that are not statements of historical facts. Forward-looking
statements may be identified by the use of words such as "anticipates",
"estimates", "expects", "intends", "plans", "predicts", "projects", and similar
expressions. From time to time, we may publish or otherwise make available
forward-looking statements of this nature. All such forward-looking statements,
whether written or oral, and whether made by or on behalf of UniSource Energy or
TEP, are expressly qualified by these cautionary statements and any other
cautionary statements which may accompany the forward-looking statements. In
addition, UniSource Energy and TEP disclaim any obligation to update any
forward-looking statements to reflect events or circumstances after the date of
this report.
Forward-looking statements involve risks and uncertainties, which could
cause actual results or outcomes to differ materially from those expressed in
the forward-looking statements. We express our expectations, beliefs and
K-65
projections in good faith and believe them to have a reasonable basis. However,
we make no assurances that management's expectations, beliefs or projections
will be achieved or accomplished. We have identified the following important
factors that could cause actual results to differ materially from those
discussed in our forward-looking statements. These may be in addition to other
factors and matters discussed in other parts of this report:
1. Effects of restructuring initiatives in the electric industry and
other energy-related industries.
2. Effects of competition in retail and wholesale energy markets.
3. Changes in economic conditions, demographic patterns and weather
conditions in our retail service areas.
4. Supply and demand conditions in wholesale energy markets, including
volatility in market prices and illiquidity in markets, which are
affected by a variety of factors. These factors include the
availability of generating capacity in the western U.S., including
hydroelectric resources, weather, natural gas prices, the extent of
utility restructuring in various states, transmission constraints,
environmental regulations and cost of compliance, FERC regulation of
wholesale energy markets, and economic conditions in the western U.S.
5. The creditworthiness of the entities with which we transact business
or have transacted business.
6. Changes affecting our cost of providing electrical service including
changes in fuel costs, generating unit operating performance,
scheduled and unscheduled plant outages, interest rates, tax laws,
environmental laws, and the general rate of inflation.
7. Changes in governmental policies and regulatory actions with respect
to financing and rate structures.
8. Changes affecting the cost of competing energy alternatives, including
changes in available generating technologies and changes in the cost
of natural gas.
9. Changes in accounting principles or the application of such principles
to our businesses.
10. Changes in the depreciable lives of our assets.
11. Market conditions and technological changes affecting our unregulated
businesses.
12. Unanticipated changes in future liabilities relating to employee
benefit plans due to changes in market values of retirement plan
assets and health care costs.
13. The outcome of any ongoing or future litigation.
14. Ability to obtain financing through debt and/or equity issuance, which
can be affected by various factors, including interest rate
fluctuations and capital market conditions.
ITEM 7A. - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
---------------------------------------------------------------------
MARKET RISKS
We are exposed to various forms of market risk. Changes in interest rates,
returns on marketable securities, and changes in commodity prices may affect our
future financial results.
For additional information concerning risk factors, including market risks,
see Safe Harbor for Forward-Looking Statements, above.
INTEREST RATE RISK
TEP is exposed to risk resulting from changes in interest rates on certain
of its variable rate debt obligations. At December 31, 2004 and 2003, TEP's debt
included $329 million of tax-exempt variable rate debt. The average interest
rate on TEP's variable rate debt (excluding letter of credit fees) was 1.25% in
2004 and 1.07% in 2003. TEP also has approximately $70 million in outstanding
principal amount of variable rate lease debt related to its Springerville Common
K-66
Facilities Leases. Interest on this lease debt is payable at LIBOR plus 4.25%.
The average interest rate on this lease debt was 5.92% in 2004 and 4.58% in
2003. A one percent increase (decrease) in average interest rates would result
in a decrease (increase) in TEP's pre-tax net income of approximately $4
million.
MARKETABLE SECURITIES RISK
TEP is exposed to fluctuations in the return on its marketable securities,
comprised of investments in debt securities. At December 31, 2004 and 2003, TEP
had marketable debt securities with an estimated fair value of $182 million and
$198 million. At December 31, 2004 and 2003, the fair value exceeded the
carrying value by $11 million and $19 million, respectively. These debt
securities represent TEP's investments in lease debt underlying certain of TEP's
capital lease obligations. Changes in the fair value of such debt securities do
not present a material risk to TEP, as TEP intends to hold these investments to
maturity.
RISK MANAGEMENT COMMITTEE
We have a Risk Management Committee responsible for the oversight commodity
price risk and credit risk related to the wholesale energy marketing activities
of TEP, the emissions and coal trading activities of MEG, and the fuel and power
procurement activities at TEP and UES. Our Risk Management Committee, which
meets on a quarterly basis and as needed, consists of officers from the finance,
accounting, legal, wholesale marketing, transmission and distribution
operations, and the generation operations departments of UniSource Energy. To
limit TEP's, UES' and MEG's exposure to commodity price risk, the Risk
Management Committee sets trading and hedging policies and limits, which are
reviewed frequently to respond to constantly changing market conditions. To
limit TEP's, UES' and MEG's exposure to credit risk, the Risk Management
Committee reviews counterparty credit exposure, as well as credit policies and
limits.
COMMODITY PRICE RISK
We are exposed to commodity price risk primarily relating to changes in the
market price of electricity, natural gas, coal and Emission Allowances.
TEP
To manage its exposure to energy price risk, TEP enters into forward
contracts to buy or sell energy at a specified price and future delivery period.
Generally, TEP commits to future sales based on expected excess generating
capability, forward prices and generation costs, using a diversified market
approach to provide a balance between long-term, mid-term and spot energy sales.
TEP generally enters into forward purchases during its summer peaking period to
ensure it can meet its load and reserve requirements and account for other
contracts and resource contingencies. TEP also enters into limited forward
purchases and sales to optimize its resource portfolio and take advantage of
locational differences in price. These positions are managed on both a
volumetric and dollar basis and are closely monitored using risk management
policies and procedures overseen by the Risk Management Committee. For example,
the risk management policies provide that TEP should not take a short position
in the third quarter and must have owned generation backing up all forward sales
positions at the time the sale is made. TEP's risk management policies also
restrict entering into forward positions with maturities extending beyond the
end of the next calendar year.
The majority of TEP's forward contracts are considered to be "normal
purchases and sales" of electric energy and are not considered to be derivatives
under FAS 133. TEP records revenues on its "normal sales" and expenses on its
"normal purchases" in the period in which the energy is delivered. From time to
time, however, TEP enters into forward contracts that meet the definition of a
derivative under FAS 133. When TEP has derivative forward contracts, it marks
them to market on a daily basis using actively quoted prices obtained from
brokers for power traded over-the-counter at Palo Verde and at other
southwestern U.S. trading hubs. TEP believes that these broker quotations used
to calculate the mark-to-market values represent accurate measures of the fair
values of TEP's positions, because of the short-term nature of TEP's positions,
as limited by risk management policies, and the liquidity in the short-term
market. As of December 31, 2004, all of TEP's derivative forward contracts were
for settlement within 18 months. To adjust the value of its derivative forward
contracts to fair value on its income statement, TEP recorded an unrealized gain
of $1.3 million and an unrealized loss of $0.4 million, respectively, on its
income statements for the twelve months ended December 31, 2004 and December 31,
2003. This demonstrates the limited derivative forward contract activity
conducted by TEP and the limited impact on TEP's operating results and financial
condition.
K-67
TEP is also subject to commodity price risk from changes in the price of
natural gas. TEP typically uses generation from its facilities fueled by natural
gas and purchased power, in addition to energy from its coal-fired facilities,
to meet the summer peak demands of its retail customers and to meet local
reliability needs. Some of these purchased power contracts are price indexed to
natural gas prices. Short-term and spot power purchase prices are also closely
correlated to natural gas prices. Due to its increasing seasonal gas and
purchased power usage, TEP hedges a portion of its total natural gas exposure
from plant fuel, gas-indexed purchase power and spot market purchases with fixed
price contracts for a maximum of three years. TEP purchases its remaining gas
fuel needs and purchased power in the spot and short-term markets.
In 2004, the average price of natural gas was $5.44 per MMBtu, or 11%
higher than 2003, due to low gas storage levels and reductions in gas
production. The increase in the regional supply of gas-generated energy and the
completion of a 500-kV transmission connection, in May 2003, however, allowed
TEP to limit its use of its less efficient gas generation units in favor of more
economical purchases of energy in the wholesale market. TEP's generation output
fueled by natural gas was approximately 427,000 MWh, or 4% of total generation
and purchased power in 2004. During 2004, TEP purchased a total of 1,400,000 MWh
of energy, or 11% of total generation and purchased power, of which
approximately 175,000 MWh were from gas-index priced energy under long-term
purchased power contracts with the remainder being from short-term and spot
power markets.
In January 2005, TEP entered into a purchased power agreement with Panda
Gila River. TEP will purchase 50 MW of firm energy during June through September
2005.
TEP entered into two purchased power agreements in 2003 for the period 2003
through 2006. During 2003, TEP purchased approximately 125,000 MWh under these
contracts; energy purchased under these agreements is adjusted for changes in
the price of natural gas.
UES
UES is also subject to commodity price risk, primarily from the changes in
the price of natural gas purchased for its UNS Gas customers. This risk is
mitigated through the PGA mechanism in UNS Gas' retail rates which provides an
adjustment to recover the actual costs of gas and transportation. UNS Gas
further reduces this risk by purchasing forward fixed price contracts for a
portion of its projected gas needs under its Price Stabilization Plan. UNS Gas
purchases between 45% and 80% of its estimated gas needs in this manner.
UNS Electric is not exposed to commodity price risk for its purchase of
electricity as it has a fixed price full-requirements supply agreement with PWCC
through May 2008.
MEG
During the fourth quarter of 2001, MEG began managing and trading Emission
Allowances, coal and related instruments. We manage the market risk of this line
of business by setting notional limits by product, as well as limits to the
potential change in fair market value under a 33% change in price or volatility.
We closely monitor MEG's trading activities, which include swap agreements,
options and forward contracts, using risk management policies and procedures
overseen by the Risk Management Committee. MEG marks its trading positions to
market on a daily basis using actively quoted prices obtained from brokers and
options pricing models for positions that extend through 2007. As of December
31, 2004 and December 31, 2003, the fair value of MEG's trading assets combined
with Emission Allowances it holds in escrow was $76.5 million and $21.5 million,
respectively. The fair value of MEG's trading liabilities was $65 million at
December 31, 2004 and $18.7 million at December 31, 2003. During 2004, MEG
reflected a $0.6 million unrealized gain and $0.7 million realized gain on its
income statement, compared with an unrealized gain of $1.0 million and a
realized loss of $0.4 million in 2003.
Unrealized Gain (Loss) of MEG's Trading Activities
------------------------------------------------------
Total
Source of Fair Value Maturity Maturity Maturity Unrealized Gain
At December 31, 2004 0 - 6 mos. 6 -12 mos. over 1 yr. (Loss)
- Millions of Dollars -
Prices actively quoted $ (12.1) $ - $ - $ (12.1)
Prices based on models
and other valuation
methods 8.0 0.1 5.2 13.3
--------------------------------------------------------------------------------
Total $ (4.1) $ 0.1 $ 5.2 $ 1.2
--------------------------------------------------------------------------------
K-68
MEG is in the process of winding down its activities and will not engage in
any new activities after 2005. As of January 31, 2005, the fair value of MEG's
trading assets was $62 million and the fair value of its trading liabilities was
$56 million.
CREDIT RISK
UniSource Energy is exposed to credit risk in its energy-related marketing
and trading activities related to potential nonperformance by counterparties. We
manage the risk of counterparty default by performing financial credit reviews,
setting limits monitoring exposures, requiring collateral when needed, and using
a standard agreement which allows for the netting of current period exposures to
and from a single counterparty. Despite such mitigation efforts, there is a
potential for defaults by counterparties. In the fourth quarter of 2000 and the
first quarter of 2001, TEP was affected by payment defaults by SCE and PG&E for
amounts owed to the CPX and CISO. In the fourth quarter of 2001, Enron defaulted
on amounts owed to TEP for energy sales.
We calculate counterparty credit exposure by adding any outstanding
receivable (net of amounts payable if a netting agreement exists) to the
mark-to-market value of any forward contracts. As of December 31, 2004, TEP's
total credit exposure related to its wholesale marketing activities (excluding
defaulted amounts owed by the CPX, the CISO and Enron), was approximately $17
million and MEG's total credit exposure related to its trading activities was
$17 million. TEP and MEG's credit exposure is diversified across approximately
32 counterparties. Approximately $3 million of exposure is to non-investment
grade companies. As a result of the reduction in MEG's trading activities
described above, MEG's credit exposure as of January 31, 2005, decreased to $6
million.
UniSource Energy is also exposed to credit risk related to the sale of
assets owned by Nations Energy Corporation (Nations Energy). In September 2001,
Nations Energy sold its 26% equity interest in a power project located in
Curacao, Netherlands Antilles to Mirant Curacao Investments, Ltd. (Mirant
Curacao) a subsidiary of Mirant Corporation (Mirant). Nations Energy received $5
million in cash and an $11 million note receivable from Mirant Curacao. The note
was recorded at its net present value of $8 million using an 8% discount rate,
the discount being recognized as interest income over the five-year life of the
note. As of December 31, 2004, Nations Energy's receivable from Mirant Curacao
is approximately $8 million. The note is primarily included in Investments and
Other Property-Other on UniSource Energy's balance sheet. The first payment of
$2 million on the receivable was received in July 2004. The remaining payments
on the note receivable are expected to be received as follows: $4 million in
July 2005; and $5 million in July 2006. The note is guaranteed by Mirant
Americas, Inc., a subsidiary of Mirant. On July 14, 2003, Mirant, Mirant
Americas, Inc. and various other Mirant companies filed for Chapter 11
bankruptcy protection. Mirant Curacao was not included in the Chapter 11
filings. Based on a review of the projected cash flows for the power project, it
appears Mirant Curacao will have sufficient future cash flows to pay the note
receivable and any applicable interest. However, we cannot predict the ultimate
outcome that Mirant's bankruptcy will have on the collectibility of the note
from Mirant Curacao. Nations Energy will continue to evaluate the collectibility
of the receivable, but currently expects to collect the note in its entirety and
has not recorded any reserve for this note.
ITEM 8. - CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
--------------------------------------------------------------------------------
MANAGEMENT'S REPORT ON INTERNAL CONTROLS OVER FINANCIAL REPORTING
UniSource Energy Corporation's management is responsible for establishing
and maintaining adequate internal control over financial reporting. Because of
its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.
Management assessed the effectiveness of UniSource Energy Corporation's
internal control over financial reporting as of December 31, 2004. In making
this assessment, management used the criteria set forth by the Committee of
Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control -
Integrated Framework.
Based on management's assessment using those criteria, management has
concluded that, as of December 31, 2004, UniSource Energy Corporation's internal
control over financial reporting was effective.
K-69
Our management's assessment of the effectiveness of the Company's internal
control over financial reporting as of December 31, 2004 has been audited by
PricewaterhouseCoopers LLP, an independent registered public accounting firm, as
stated in their report which appears herein.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
UniSource Energy Corporation:
We have completed an integrated audit of UniSource Energy Corporation's 2004
financial statements and of its internal control over financial reporting as of
December 31, 2004 and audits of its 2003 and 2002 consolidated financial
statements in accordance with the standards of the Public Company Accounting
Oversight Board (United States). Our opinions, based on our audits, are
presented below.
Consolidated financial statements and financial statement schedule
------------------------------------------------------------------
In our opinion, the consolidated financial statements listed in the index
appearing under Item 15(a)(1) present fairly, in all material respects, the
financial position of UniSource Energy Corporation and its subsidiaries at
December 31, 2004 and 2003, and the results of their operations and their cash
flows for each of the three years in the period ended December 31, 2004 in
conformity with accounting principles generally accepted in the United States of
America. In addition, in our opinion, the financial statement schedule listed in
the index appearing under Item 15(a)(2) presents fairly, in all material
respects, the information set forth therein when read in conjunction with the
related consolidated financial statements. These financial statements and
financial statement schedule are the responsibility of the Company's management.
Our responsibility is to express an opinion on these financial statements and
financial statement schedule based on our audits. We conducted our audits of
these statements in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit of financial statements
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements, assessing the accounting principles
used and significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
As described in Note 5 to the consolidated financial statements, the Company
changed the manner in which it accounts for asset retirement costs as of January
1, 2003.
Internal control over financial reporting
-----------------------------------------
Also, in our opinion, management's assessment, included in Management's Report
on Internal Controls Over Financial Reporting appearing under Item 8, that the
Company maintained effective internal control over financial reporting as of
December 31, 2004 based on criteria established in Internal Control-Integrated
Framework issued by the Committee of Sponsoring Organizations of the Treadway
Commission (COSO), is fairly stated, in all material respects, based on those
criteria. Furthermore, in our opinion, the Company maintained, in all material
respects, effective internal control over financial reporting as of December 31,
2004, based on criteria established in Internal Control-Integrated Framework
issued by the COSO. The Company's management is responsible for maintaining
effective internal control over financial reporting and for its assessment of
the effectiveness of internal control over financial reporting. Our
responsibility is to express opinions on management's assessment and on the
effectiveness of the Company's internal control over financial reporting based
on our audit. We conducted our audit of internal control over financial
reporting in accordance with the standards of the Public Company Accounting
Oversight Board (United States). Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether effective
internal control over financial reporting was maintained in all material
respects. An audit of internal control over financial reporting includes
obtaining an understanding of internal control over financial reporting,
evaluating management's assessment, testing and evaluating the design and
operating effectiveness of internal control, and performing such other
procedures as we consider necessary in the circumstances. We believe that our
audit provides a reasonable basis for our opinions.
A company's internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles. A company's internal control over
financial reporting includes those policies and procedures that (i) pertain to
K-70
the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the company; (ii)
provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (iii) provide reasonable assurance regarding prevention or
timely detection of unauthorized acquisition, use, or disposition of the
company's assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting
may not prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.
/s/ PricewaterhouseCoopers LLP
------------------------------
PricewaterhouseCoopers LLP
Los Angeles, California
March 16, 2005
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
Tucson Electric Power Company:
In our opinion, the consolidated financial statements listed in the index
appearing under Item 15(a)(1) present fairly, in all material respects, the
financial position of Tucson Electric Power Company and its subsidiaries at
December 31, 2004 and 2003, and the results of their operations and their cash
flows for each of the three years in the period ended December 31, 2004 in
conformity with accounting principles generally accepted in the United States of
America. In addition, in our opinion, the financial statement schedule listed in
the index appearing under Item 15(a)(2) presents fairly, in all material
respects, the information set forth therein when read in conjunction with the
related consolidated financial statements. These financial statements and
financial statement schedule are the responsibility of the Company's management.
Our responsibility is to express an opinion on these financial statements and
financial statement schedule based on our audits. We conducted our audits of
these statements in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
As described in Note 5 to the consolidated financial statements, the Company
changed the manner in which it accounts for asset retirement costs as of January
1, 2003.
/s/ PricewaterhouseCoopers LLP
------------------------------
PricewaterhouseCoopers LLP
Los Angeles, California
March 16, 2005
K-71
UNISOURCE ENERGY CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
Years Ended December 31,
2004 2003 2002
------------------------------------------------------------------------------------------------------------------
- Thousands of Dollars -
OPERATING REVENUES
Electric Retail Sales $ 862,258 $ 746,578 $ 668,721
Electric Wholesale Sales 160,154 151,111 157,108
Gas Revenue 126,666 46,520 -
Other Revenues 19,900 28,546 13,747
------------------------------------------------------------------------------------------------------------------
TOTAL OPERATING REVENUES 1,168,978 972,755 839,576
------------------------------------------------------------------------------------------------------------------
OPERATING EXPENSES
Fuel 212,514 210,163 209,712
Purchased Energy 250,668 132,754 43,171
Coal Contract Termination Fee - - 11,250
Other Operations and Maintenance 252,711 216,323 188,910
Depreciation and Amortization 135,315 130,643 127,923
Amortization of Transition Recovery Asset 50,153 31,752 24,489
Taxes Other Than Income Taxes 48,227 48,115 45,508
------------------------------------------------------------------------------------------------------------------
TOTAL OPERATING EXPENSES 949,588 769,750 650,963
------------------------------------------------------------------------------------------------------------------
OPERATING INCOME 219,390 203,005 188,613
------------------------------------------------------------------------------------------------------------------
OTHER INCOME (DEDUCTIONS)
Interest Income 20,192 20,493 20,654
Other Income 15,030 7,306 6,200
Other Expense (6,439) (5,620) (8,026)
------------------------------------------------------------------------------------------------------------------
TOTAL OTHER INCOME (DEDUCTIONS) 28,783 22,179 18,828
------------------------------------------------------------------------------------------------------------------
INTEREST EXPENSE
Long-Term Debt 82,807 80,844 65,620
Interest on Capital Leases 85,912 84,080 87,801
Other Interest Expense, Net of Amounts Capitalized (411) 1,708 1,130
------------------------------------------------------------------------------------------------------------------
TOTAL INTEREST EXPENSE 168,308 166,632 154,551
------------------------------------------------------------------------------------------------------------------
INCOME BEFORE INCOME TAXES AND CUMULATIVE EFFECT OF ACCOUNTING CHANGE 79,865 58,552 52,890
Income Tax Expense 33,946 12,082 17,962
------------------------------------------------------------------------------------------------------------------
INCOME BEFORE CUMULATIVE EFFECT OF ACCOUNTING CHANGE 45,919 46,470 34,928
CUMULATIVE EFFECT OF ACCOUNTING CHANGE - NET OF TAX - 67,471 -
------------------------------------------------------------------------------------------------------------------
NET INCOME $ 45,919 $ 113,941 $ 34,928
==================================================================================================================
WEIGHTED-AVERAGE SHARES OF COMMON STOCK OUTSTANDING (000) 34,380 33,828 33,665
==================================================================================================================
BASIC EARNINGS PER SHARE
INCOME BEFORE CUMULATIVE EFFECT OF ACCOUNTING CHANGE $1.34 $1.38 $1.04
CUMULATIVE EFFECT OF ACCOUNTING CHANGE - NET OF TAX - $1.99 -
------------------------------------------------------------------------------------------------------------------
NET INCOME $1.34 $3.37 $1.04
==================================================================================================================
DILUTED EARNINGS PER SHARE
INCOME BEFORE CUMULATIVE EFFECT OF ACCOUNTING CHANGE $1.31 $1.35 $1.02
CUMULATIVE EFFECT OF ACCOUNTING CHANGE - NET OF TAX - $1.97 -
------------------------------------------------------------------------------------------------------------------
NET INCOME $1.31 $3.32 $1.02
==================================================================================================================
DIVIDENDS PAID PER SHARE $0.64 $0.60 $0.50
==================================================================================================================
See Notes to Consolidated Financial Statements.
K-72
UNISOURCE ENERGY CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31,
2004 2003 2002
------------------------------------------------------------------------------------------------------------------
- Thousands of Dollars -
CASH FLOWS FROM OPERATING ACTIVITIES
Cash Receipts from Electric Retail Sales $ 931,450 $ 814,425 $ 731,404
Cash Receipts from Electric Wholesale Sales 204,902 203,717 248,305
Cash Receipts from Gas Sales 136,386 38,306 -
Other Cash Receipts 18,837 11,982 28,047
MEG Cash Receipts from Trading Activity 170,506 101,368 57,889
UED Springerville 3 Financial Closing Proceeds - 43,265 -
Interest Received 22,608 22,428 13,820
Income Tax Refunds Received 5,427 17,093 921
Deposit-Second Mortgage Indenture 17,040 (17,040) -
Fuel Costs Paid (208,549) (204,920) (201,124)
Purchased Energy Costs Paid (286,115) (187,933) (135,320)
Wages Paid, Net of Amounts Capitalized (92,781) (82,482) (75,479)
Payment of Other Operations and Maintenance Costs (124,786) (114,864) (124,417)
MEG Cash Payments for Trading Activity (162,609) (100,963) (63,766)
Capital Lease Interest Paid (70,752) (74,865) (68,975)
Taxes Paid, Net of Amounts Capitalized (139,637) (110,391) (106,550)
Interest Paid, Net of Amounts Capitalized (75,957) (73,565) (62,241)
Income Taxes Paid (20,483) (6,716) (29,238)
Coal Contract Termination and Amendment Fees Paid - - (26,649)
Performance Deposits (6,487) (3,124) 6,147
Other Cash Payments (12,021) (12,325) (16,337)
------------------------------------------------------------------------------------------------------------------
NET CASH FLOWS - OPERATING ACTIVITIES 306,979 263,396 176,437
------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES
Capital Expenditures (153,684) (137,282) (112,706)
Capital Expenditure for Luna Energy Facility Assets (13,333) - -
Purchase of Citizens Assets - (223,430) -
Proceeds from Investment in Springerville Lease Debt and Equity 11,590 12,078 3,078
Return of Investment from Millennium Energy Businesses 10,120 - -
Other Proceeds from Investing Activities 2,712 1,876 1,590
Payments for Investment in Springerville Lease Debt and Equity (4,499) - (138,067)
Investments in and Loans to Equity Investees (4,095) (2,072) (23,592)
Other Payments for Investing Activities (5,000) (1,902) (1,193)
------------------------------------------------------------------------------------------------------------------
NET CASH FLOWS - INVESTING ACTIVITIES (156,189) (350,732) (270,890)
------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES
Payments of Capital Lease Obligations (49,378) (42,657) (19,842)
Repayment of Long-Term Debt (28,732) (2,976) (2,138)
Payment of Debt Issue Costs (9,364) (3,283) (5,410)
Proceeds from Borrowings under the Revolving Credit Facility 20,000 45,000 -
Payments for Borrowings under the Revolving Credit Facility (20,000) (45,000) -
Proceeds from Issuance of Short-Term Debt - 36,125 1,194
Repayments of Short-Term Debt - (35,960) (1,078)
Proceeds from Issuance of Long-Term Debt - 160,000 -
Common Stock Dividends Paid (21,879) (20,208) (16,806)
Other Proceeds from Financing Activities 12,657 7,949 2,249
Other Payments for Financing Activities (1,332) (1,316) (942)
------------------------------------------------------------------------------------------------------------------
NET CASH FLOWS - FINANCING ACTIVITIES (98,028) 97,674 (42,773)
------------------------------------------------------------------------------------------------------------------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 52,762 10,338 (137,226)
CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR 101,266 90,928 228,154
------------------------------------------------------------------------------------------------------------------
CASH AND CASH EQUIVALENTS, END OF YEAR $ 154,028 $ 101,266 $ 90,928
==================================================================================================================
See Note 20 for supplemental cash flow information.
See Notes to Consolidated Financial Statements.
K-73
UNISOURCE ENERGY CORPORATION
CONSOLIDATED BALANCE SHEETS
December 31,
2004 2003
-----------------------------------------------------------------------------------------------------
ASSETS - Thousands of Dollars -
UTILITY PLANT
Plant in Service $ 3,033,405 $ 2,899,305
Utility Plant under Capital Leases 723,901 748,239
Construction Work in Progress 116,161 105,804
-----------------------------------------------------------------------------------------------------
TOTAL UTILITY PLANT 3,873,467 3,753,348
Less Accumulated Depreciation and Amortization (1,348,017) (1,262,962)
Less Accumulated Amortization of Capital Lease Assets (444,313) (421,171)
-----------------------------------------------------------------------------------------------------
TOTAL UTILITY PLANT - NET 2,081,137 2,069,215
-----------------------------------------------------------------------------------------------------
INVESTMENTS AND OTHER PROPERTY
Investments in Lease Debt 170,893 178,789
Other 85,035 109,570
-----------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS AND OTHER PROPERTY 255,928 288,359
-----------------------------------------------------------------------------------------------------
CURRENT ASSETS
Cash and Cash Equivalents 154,028 101,266
Trade Accounts Receivable 107,694 97,904
Unbilled Accounts Receivable 55,350 53,590
Allowance for Doubtful Accounts (16,492) (11,522)
Materials and Fuel Inventory 62,225 58,299
Trading Assets 70,958 19,987
Current Regulatory Assets 11,515 12,129
Deferred Income Taxes - Current 24,055 15,925
Interest Receivable - Current 10,475 11,561
Other 26,751 21,534
-----------------------------------------------------------------------------------------------------
TOTAL CURRENT ASSETS 506,559 380,673
-----------------------------------------------------------------------------------------------------
REGULATORY AND OTHER ASSETS
Transition Recovery Asset 224,029 274,182
Income Taxes Recoverable Through Future Revenues 44,624 49,849
Other Regulatory Assets 13,961 12,327
Other Assets 49,280 48,114
-----------------------------------------------------------------------------------------------------
TOTAL REGULATORY AND OTHER ASSETS 331,894 384,472
-----------------------------------------------------------------------------------------------------
TOTAL ASSETS $ 3,175,518 $ 3,122,719
=====================================================================================================
CAPITALIZATION AND OTHER LIABILITIES
CAPITALIZATION
Common Stock Equity $ 580,718 $ 556,472
Capital Lease Obligations 701,931 762,968
Long-Term Debt 1,257,595 1,286,320
-----------------------------------------------------------------------------------------------------
TOTAL CAPITALIZATION 2,540,244 2,605,760
-----------------------------------------------------------------------------------------------------
CURRENT LIABILITIES
Current Obligations under Capital Leases 53,694 50,269
Current Maturities of Long-Term Debt 1,725 1,742
Accounts Payable 95,276 65,745
Interest Accrued 60,679 62,927
Trading Liabilities 65,022 18,238
Taxes Accrued 53,192 50,625
Accrued Employee Expenses 19,216 16,081
Other 19,350 16,256
-----------------------------------------------------------------------------------------------------
TOTAL CURRENT LIABILITIES 368,154 281,883
-----------------------------------------------------------------------------------------------------
DEFERRED CREDITS AND OTHER LIABILITIES
Deferred Income Taxes - Noncurrent 101,753 96,270
Regulatory Liability - Net Cost of Removal for Interim Retirements 69,585 60,998
Other 95,782 77,808
-----------------------------------------------------------------------------------------------------
TOTAL DEFERRED CREDITS AND OTHER LIABILITIES 267,120 235,076
-----------------------------------------------------------------------------------------------------
COMMITMENTS AND CONTINGENCIES (NOTE 8)
-----------------------------------------------------------------------------------------------------
TOTAL CAPITALIZATION AND OTHER LIABILITIES $ 3,175,518 $ 3,122,719
=====================================================================================================
See Notes to Consolidated Financial Statements.
K-74
UNISOURCE ENERGY CORPORATION
CONSOLIDATED STATEMENTS OF CAPITALIZATION
December 31,
2004 2003
---------------------------------------------------------------------------------------------------------------------------
COMMON STOCK EQUITY - Thousands of Dollars -
Common Stock--No Par Value $ 677,119 $ 668,022
2004 2003
------------------------------------
Shares Authorized 75,000,000 75,000,000
Shares Outstanding 34,255,070 33,787,942
Accumulated Deficit (85,666) (109,706)
Accumulated Other Comprehensive Loss (10,735) (1,844)
---------------------------------------------------------------------------------------------------------------------------
TOTAL COMMON STOCK EQUITY 580,718 556,472
---------------------------------------------------------------------------------------------------------------------------
PREFERRED STOCK
No Par Value, 1,000,000 Shares Authorized, None Outstanding - -
---------------------------------------------------------------------------------------------------------------------------
CAPITAL LEASE OBLIGATIONS
Springerville Unit 1 459,815 484,219
Springerville Coal Handling Facilities 126,538 129,415
Springerville Common Facilities 105,529 125,717
Sundt Unit 4 62,607 72,196
Other Leases 1,136 1,690
---------------------------------------------------------------------------------------------------------------------------
Total Capital Lease Obligations 755,625 813,237
Less Current Maturities (53,694) (50,269)
---------------------------------------------------------------------------------------------------------------------------
TOTAL LONG-TERM CAPITAL LEASE OBLIGATIONS 701,931 762,968
---------------------------------------------------------------------------------------------------------------------------
LONG-TERM DEBT
ISSUE MATURITY INTEREST RATE
---------------------------------------------------------------------------------------------------------------------------
First Mortgage Bonds
Corporate 2009 8.50% - 27,000
Industrial Development Revenue Bonds (IDBs) 2006 - 2008 6.10% to 7.50% 53,150 54,875
First Collateral Trust Bonds 2008 7.50% 138,300 138,300
Second Mortgage IDBs* 2018 - 2022 Variable** 328,600 328,600
Unsecured IDBs 2020 - 2033 5.85% to 7.13% 579,270 579,270
Senior Unsecured Notes 2008 - 2015 6.23% to 7.61% 160,000 160,000
Other Long-Term Debt - 17
---------------------------------------------------------------------------------------------------------------------------
Total Stated Principal Amount 1,259,320 1,288,062
Less Current Maturities (1,725) (1,742)
---------------------------------------------------------------------------------------------------------------------------
TOTAL LONG-TERM DEBT 1,257,595 1,286,320
---------------------------------------------------------------------------------------------------------------------------
TOTAL CAPITALIZATION $ 2,540,244 $ 2,605,760
===========================================================================================================================
* The Second Mortgage IDBs (defined below) are backed by $341 million of LOCs
under TEP's Credit Agreement. TEP's obligations under the Credit Agreement are
collateralized with Second Mortgage Bonds. At December 31, 2004, the annual LOC
fees (including fronting fees) were 2.60%. At December 31, 2003, the annual LOC
fees (including fronting fees) ranged from 4.25% to 5.75%. See Note 10.
** Weighted average interest rates on variable rate tax-exempt debt (IDBs)
ranged from 0.78% to 2.01% during 2004 and 2003, and the average interest rate
on such debt was 1.25% in 2004 and 1.07% in 2003.
UniSource Energy also has stock options outstanding. See Note 17.
See Notes to Consolidated Financial Statements.
K-75
UNISOURCE ENERGY CORPORATION
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
ACCUMULATED
COMMON ACCUMULATED OTHER TOTAL
SHARES COMMON EARNINGS COMPREHENSIVE STOCKHOLDERS'
OUTSTANDING* STOCK (DEFICIT) INCOME (LOSS) EQUITY
------------------------------------------------------------------------------------------------------------------------------
- In Thousands -
BALANCES AT DECEMBER 31, 2001 33,502 $ 662,694 $ (221,561) $ - $ 441,133
Comprehensive Income:
2002 Net Income - - 34,928 - 34,928
Minimum Pension Liability
(net of $2,639 income tax benefit) - - - (4,024) (4,024)
------------
Total Comprehensive Income 30,904
------------
Dividends Declared - - (16,806) - (16,806)
Shares Issued under Stock Compensation Plans 9 80 - - 80
Shares Distributed by Deferred Compensation Trust 3 48 - - 48
Shares Issued for Stock Options 65 934 - - 934
Other - 347 - - 347
---------------------------------------------------------------------------------------------------------------------------
BALANCES AT DECEMBER 31, 2002 33,579 664,103 (203,439) (4,024) 456,640
Comprehensive Income:
2003 Net Income - - 113,941 - 113,941
Minimum Pension Liability Adjustment
(net of $1,430 income tax expense) - - - 2,180 2,180
------------
Total Comprehensive Income 116,121
------------
Dividends Declared - - (20,208) - (20,208)
Shares Issued under Stock Compensation Plans 7 55 - - 55
Shares Distributed by Deferred Compensation Trust 3 52 - - 52
Shares Issued for Stock Options 199 3,489 - - 3,489
Other - 323 - - 323
---------------------------------------------------------------------------------------------------------------------------
BALANCES AT DECEMBER 31, 2003 33,788 668,022 (109,706) (1,844) 556,472
Comprehensive Income:
2004 Net Income - - 45,919 - 45,919
Minimum Pension Liability Adjustment
(net of $6,858 income tax benefit) - - - (10,460) (10,460)
Unrealized Gain on Cash Flow Hedges
(net of $960 income tax expense) - - - 1,465 1,465
Reclassification of Realized Loss on
Cash Flow Hedges to Net Income
(net of $68 income tax benefit) - - - 104 104
------------
Total Comprehensive Income 37,028
------------
Dividends Declared - - (21,879) - (21,879)
Shares Issued under Stock Compensation Plans 63 1,307 - - 1,307
Shares Distributed by Deferred Compensation Trust 4 50 - - 50
Shares Issued for Stock Options 400 7,576 - - 7,576
Other - 164 - - 164
---------------------------------------------------------------------------------------------------------------------------
BALANCES AT DECEMBER 31, 2004 34,255 $ 677,119 $ (85,666) $ (10,735) $ 580,718
===========================================================================================================================
* UniSource Energy has 75 million authorized shares of common stock.
We describe limitations on our ability to pay dividends in Note 12.
See Notes to Consolidated Financial Statements.
K-76
TUCSON ELECTRIC POWER COMPANY
CONSOLIDATED STATEMENTS OF INCOME
Years Ended December 31,
2004 2003 2002
----------------------------------------------------------------------------------------------------------
- Thousands of Dollars -
OPERATING REVENUES
Electric Retail Sales $ 719,341 $ 691,503 $ 668,721
Electric Wholesale Sales 159,918 151,030 157,108
Other Revenues 10,039 9,018 8,618
----------------------------------------------------------------------------------------------------------
TOTAL OPERATING REVENUES 889,298 851,551 834,447
----------------------------------------------------------------------------------------------------------
OPERATING EXPENSES
Fuel 212,514 210,163 209,712
Purchased Power 72,558 65,127 43,171
Coal Contract Termination Fee - - 11,250
Other Operations and Maintenance 190,347 170,086 163,084
Depreciation and Amortization 117,109 121,037 124,054
Amortization of Transition Recovery Asset 50,153 31,752 24,489
Taxes Other Than Income Taxes 39,933 42,388 44,228
----------------------------------------------------------------------------------------------------------
TOTAL OPERATING EXPENSES 682,614 640,553 619,988
----------------------------------------------------------------------------------------------------------
OPERATING INCOME 206,684 210,998 214,459
----------------------------------------------------------------------------------------------------------
OTHER INCOME (DEDUCTIONS)
Interest Income 20,021 20,328 20,094
Interest Income - Note Receivable from UniSource Energy 9,329 10,242 9,329
Other Income 6,520 3,272 3,570
Other Expense (4,600) (1,604) (1,779)
----------------------------------------------------------------------------------------------------------
TOTAL OTHER INCOME (DEDUCTIONS) 31,270 32,238 31,214
----------------------------------------------------------------------------------------------------------
INTEREST EXPENSE
Long-Term Debt 71,743 76,585 65,620
Interest on Capital Leases 85,869 84,053 87,783
Other Interest Expense, Net of Amounts Capitalized (600) 66 446
----------------------------------------------------------------------------------------------------------
TOTAL INTEREST EXPENSE 157,012 160,704 153,849
----------------------------------------------------------------------------------------------------------
INCOME BEFORE INCOME TAXES AND
CUMULATIVE EFFECT OF ACCOUNTING CHANGE 80,942 82,532 91,824
Income Tax Expense 34,815 21,090 36,434
----------------------------------------------------------------------------------------------------------
INCOME BEFORE CUMULATIVE EFFECT OF ACCOUNTING CHANGE 46,127 61,442 55,390
CUMULATIVE EFFECT OF ACCOUNTING CHANGE - NET OF TAX - 67,471 -
----------------------------------------------------------------------------------------------------------
NET INCOME $ 46,127 $ 128,913 $ 55,390
==========================================================================================================
See Notes to Consolidated Financial Statements.
K-77
TUCSON ELECTRIC POWER COMPANY
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31,
2004 2003 2002
--------------------------------------------------------------------------------------------------------------
- Thousands of Dollars -
CASH FLOWS FROM OPERATING ACTIVITIES
Cash Receipts from Electric Retail Sales $ 780,335 $ 753,424 $ 731,404
Cash Receipts from Electric Wholesale Sales 204,643 203,644 248,305
Interest Received 21,928 22,049 13,288
Interest Received from UniSource Energy - 19,571 -
Income Tax Refunds Received 3,712 16,926 921
Deposit-Second Mortgage Indenture 17,040 (17,040) -
Other Cash Receipts 8,720 3,935 4,975
Fuel Costs Paid (208,549) (204,920) (201,124)
Purchased Power Costs Paid (115,323) (119,635) (135,320)
Wages Paid, Net of Amounts Capitalized (68,832) (63,409) (60,871)
Payment of Other Operations and Maintenance Costs (99,382) (96,380) (103,638)
Capital Lease Interest Paid (70,748) (74,851) (68,911)
Taxes Paid, Net of Amounts Capitalized (102,648) (100,622) (101,866)
Interest Paid, Net of Amounts Capitalized (65,504) (73,071) (62,209)
Income Taxes Paid (21,402) (5,230) (29,109)
Coal Contract Termination and Amendment Fees Paid - - (26,649)
Other Cash Payments (8,839) (3,402) (2,205)
--------------------------------------------------------------------------------------------------------------
NET CASH FLOWS - OPERATING ACTIVITIES 275,151 260,989 206,991
--------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES
Capital Expenditures (116,172) (121,854) (103,307)
Capital Expenditure for Luna Energy Facility Assets (13,333) - -
Proceeds from Investment in Springerville Lease Debt and Equity 11,590 12,078 3,078
Other Proceeds from Investing Activities 1,652 1,232 -
Payments for Investment in Springerville Lease Debt and Equity (4,499) - (138,067)
Purchase of North Loop Gas Turbine from UED - - (14,853)
Other Payments for Investing Activities (5,000) (1,902) (1,193)
--------------------------------------------------------------------------------------------------------------
NET CASH FLOWS - INVESTING ACTIVITIES (125,762) (110,446) (254,342)
--------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES
Payments of Capital Lease Obligations (49,431) (42,553) (19,544)
Repayments of Long-Term Debt (28,725) (2,090) (2,114)
Proceeds from Borrowings under Revolving Credit Facility 20,000 45,000 -
Payments for Borrowings under Revolving Credit Facility (20,000) (45,000) -
Payment of Debt Issue Costs (8,890) (788) (5,410)
Dividends Paid to UniSource Energy (31,500) (80,000) (35,000)
Other Proceeds from Financing Activities 18,435 1,916 6,458
Other Payments for Financing Activities (1,333) (17,544) (941)
--------------------------------------------------------------------------------------------------------------
NET CASH FLOWS - FINANCING ACTIVITIES (101,444) (141,059) (56,551)
--------------------------------------------------------------------------------------------------------------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 47,945 9,484 (103,902)
CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR 65,262 55,778 159,680
--------------------------------------------------------------------------------------------------------------
CASH AND CASH EQUIVALENTS, END OF YEAR $ 113,207 $ 65,262 $ 55,778
==============================================================================================================
See Note 20 for supplemental cash flow information.
See Notes to Consolidated Financial Statements.
K-78
TUCSON ELECTRIC POWER COMPANY
CONSOLIDATED BALANCE SHEETS
December 31,
2004 2003
-----------------------------------------------------------------------------------------------------------
ASSETS - Thousands of Dollars -
UTILITY PLANT
Plant in Service $ 2,771,665 $ 2,681,133
Utility Plant under Capital Leases 723,195 747,533
Construction Work in Progress 94,336 82,210
-----------------------------------------------------------------------------------------------------------
TOTAL UTILITY PLANT 3,589,196 3,510,876
Less Accumulated Depreciation and Amortization (1,328,228) (1,257,585)
Less Accumulated Amortization of Capital Lease Assets (444,186) (421,135)
-----------------------------------------------------------------------------------------------------------
TOTAL UTILITY PLANT - NET 1,816,782 1,832,156
-----------------------------------------------------------------------------------------------------------
INVESTMENTS AND OTHER PROPERTY
Investments in Lease Debt 170,893 178,789
Other 23,393 41,285
-----------------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS AND OTHER PROPERTY 194,286 220,074
-----------------------------------------------------------------------------------------------------------
NOTE RECEIVABLE FROM UNISOURCE ENERGY 79,462 70,132
-----------------------------------------------------------------------------------------------------------
CURRENT ASSETS
Cash and Cash Equivalents 113,207 65,262
Trade Accounts Receivable 72,042 70,415
Unbilled Accounts Receivable 33,179 31,104
Allowance for Doubtful Accounts (14,166) (11,034)
Intercompany Accounts Receivable 10,111 10,938
Materials and Fuel Inventory 51,207 50,107
Current Regulatory Assets 9,653 8,969
Deferred Income Taxes - Current 24,157 18,847
Interest Receivable - Current 10,475 11,561
Other 18,330 8,861
-----------------------------------------------------------------------------------------------------------
TOTAL CURRENT ASSETS 328,195 265,030
-----------------------------------------------------------------------------------------------------------
REGULATORY AND OTHER ASSETS
Transition Recovery Asset 224,029 274,182
Income Taxes Recoverable Through Future Revenues 44,624 49,849
Other Regulatory Assets 13,684 11,973
Other Assets 41,106 43,651
-----------------------------------------------------------------------------------------------------------
TOTAL REGULATORY AND OTHER ASSETS 323,443 379,655
-----------------------------------------------------------------------------------------------------------
TOTAL ASSETS $ 2,742,168 $ 2,767,047
===========================================================================================================
CAPITALIZATION AND OTHER LIABILITIES
CAPITALIZATION
Common Stock Equity $ 414,510 $ 406,054
Capital Lease Obligations 701,405 762,323
Long-Term Debt 1,097,595 1,126,320
------------------------------------------------------------------------------------------------------------
TOTAL CAPITALIZATION 2,213,510 2,294,697
------------------------------------------------------------------------------------------------------------
CURRENT LIABILITIES
Current Obligations under Capital Leases 53,611 50,126
Current Maturities of Long-Term Debt 1,725 1,725
Accounts Payable 46,377 37,998
Intercompany Accounts Payable 20,026 8,413
Interest Accrued 56,514 58,620
Taxes Accrued 44,938 38,024
Accrued Employee Expenses 17,594 14,716
Other 9,592 8,480
------------------------------------------------------------------------------------------------------------
TOTAL CURRENT LIABILITIES 250,377 218,102
------------------------------------------------------------------------------------------------------------
DEFERRED CREDITS AND OTHER LIABILITIES
Deferred Income Taxes - Noncurrent 129,842 128,336
Regulatory Liability - Net Cost of Removal for Interim Retirements 67,485 60,417
Other 80,954 65,495
------------------------------------------------------------------------------------------------------------
TOTAL DEFERRED CREDITS AND OTHER LIABILITIES 278,281 254,248
------------------------------------------------------------------------------------------------------------
COMMITMENTS AND CONTINGENCIES (NOTE 8)
------------------------------------------------------------------------------------------------------------
TOTAL CAPITALIZATION AND OTHER LIABILITIES $ 2,742,168 $ 2,767,047
============================================================================================================
See Notes to Consolidated Financial Statements.
K-79
TUCSON ELECTRIC POWER COMPANY
CONSOLIDATED STATEMENTS OF CAPITALIZATION
December 31,
2004 2003
---------------------------------------------------------------------------------------------------------------------------------
COMMON STOCK EQUITY - Thousands of Dollars -
Common Stock--No Par Value $ 658,254 $ 655,534
2004 2003
--------------------------------
Shares Authorized 75,000,000 75,000,000
Shares Outstanding* 32,139,555 32,139,555
Capital Stock Expense (6,357) (6,357)
Accumulated Deficit (226,652) (241,279)
Accumulated Other Comprehensive Loss (10,735) (1,844)
----------------------------------------------------------------------------------------------------------------------------------
TOTAL COMMON STOCK EQUITY 414,510 406,054
----------------------------------------------------------------------------------------------------------------------------------
PREFERRED STOCK
No Par Value, 1,000,000 Shares Authorized, None Outstanding - -
----------------------------------------------------------------------------------------------------------------------------------
CAPITAL LEASE OBLIGATIONS
Springerville Unit 1 459,815 484,219
Springerville Coal Handling Facilities 126,538 129,415
Springerville Common Facilities 105,529 125,717
Sundt Unit 4 62,607 72,196
Other Leases 527 902
----------------------------------------------------------------------------------------------------------------------------------
Total Capital Lease Obligations 755,016 812,449
Less Current Maturities (53,611) (50,126)
----------------------------------------------------------------------------------------------------------------------------------
TOTAL LONG-TERM CAPITAL LEASE OBLIGATIONS 701,405 762,323
----------------------------------------------------------------------------------------------------------------------------------
LONG-TERM DEBT
ISSUE MATURITY INTEREST RATE
----------------------------------------------------------------------------------------------------------------------------------
First Mortgage Bonds
Corporate 2009 8.50% - 27,000
Industrial Development Revenue Bonds (IDBs) 2006 - 2008 6.10% to 7.50% 53,150 54,875
First Collateral Trust Bonds 2008 7.50% 138,300 138,300
Second Mortgage IDBs** 2018 - 2022 Variable*** 328,600 328,600
Unsecured IDBs 2020 - 2033 5.85% to 7.13% 579,270 579,270
----------------------------------------------------------------------------------------------------------------------------------
Total Stated Principal Amount 1,099,320 1,128,045
Less Current Maturities (1,725) (1,725)
----------------------------------------------------------------------------------------------------------------------------------
TOTAL LONG-TERM DEBT 1,097,595 1,126,320
----------------------------------------------------------------------------------------------------------------------------------
TOTAL CAPITALIZATION $ 2,213,510 $ 2,294,697
==================================================================================================================================
* UniSource Energy is the holder of all but 121 shares of TEP's outstanding
common stock.
** The Second Mortgage IDBs are backed by $341 million of LOCs under TEP's
Credit Agreement. TEP's obligations under the Credit Agreement are
collateralized with Second Mortgage Bonds. At December 31, 2004, the annual LOC
fees (including fronting fees) were 2.60%. At December 31, 2003, the annual LOC
fees (including fronting fees) ranged from 4.25% to 5.75%. See Note 10.
*** Weighted average interest rates on variable rate tax-exempt debt (IDBs)
ranged from 0.78% to 2.01% during 2004 and 2003, and the average interest rate
on such debt was 1.25% in 2004 and 1.07% in 2003.
See Notes to Consolidated Financial Statements.
K-80
TUCSON ELECTRIC POWER COMPANY
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
ACCUMULATED
CAPITAL ACCUMULATED OTHER TOTAL
COMMON STOCK EARNINGS COMPREHENSIVE STOCKHOLDERS'
STOCK EXPENSE (DEFICIT) INCOME (LOSS) EQUITY
-----------------------------------------------------------------------------------------------------------------------------------
- Thousands of Dollars -
BALANCES AT DECEMBER 31, 2001 $ 654,021 $ (6,357) $ (310,582) $ - $ 337,082
Comprehensive Income:
2002 Net Income - - 55,390 - 55,390
Minimum Pension Liability
(net of $2,639 income tax benefit) - - - (4,024) (4,024)
-----------
Total Comprehensive Income 51,366
-----------
Dividends Paid - - (35,000) - (35,000)
Capital Contribution from UniSource Energy 346 - - - 346
Other 38 - - - 38
----------------------------------------------------------------------------------------------------------------------------------
BALANCES AT DECEMBER 31, 2002 654,405 (6,357) (290,192) (4,024) 353,832
Comprehensive Income:
2003 Net Income - - 128,913 - 128,913
Minimum Pension Liability Adjustment
(net of $1,430 income tax expense) - - - 2,180 2,180
-----------
Total Comprehensive Income 131,093
-----------
Dividends Paid - - (80,000) - (80,000)
Capital Contribution from UniSource Energy 1,129 - - - 1,129
----------------------------------------------------------------------------------------------------------------------------------
BALANCES AT DECEMBER 31, 2003 655,534 (6,357) (241,279) (1,844) 406,054
Comprehensive Income:
2004 Net Income - - 46,127 - 46,127
Minimum Pension Liability Adjustment
(net of $6,858 income tax benefit) - - - (10,460) (10,460)
Unrealized Gain on Cash Flow Hedges
(net of $960 income tax expense) - - - 1,465 1,465
Reclassification of Realized Loss on
Cash Flow Hedges to Net Income
(net of $68 income tax benefit) - - - 104 104
-----------
Total Comprehensive Income 37,236
-----------
Dividends Paid - - (31,500) - (31,500)
Capital Contribution from UniSource Energy 2,720 - - - 2,720
----------------------------------------------------------------------------------------------------------------------------------
BALANCES AT DECEMBER 31, 2004 $ 658,254 $ (6,357) $ (226,652) $ (10,735) $ 414,510
===================================================================================================================================
We describe limitations on TEP's ability to pay dividends in Note 12.
See Notes to Consolidated Financial Statements.
K-81
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
NOTE 1. NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
----------------------------------------------------------------------------
NATURE OF OPERATIONS
UniSource Energy Corporation (UniSource Energy) is an exempt holding
company under the Public Utility Holding Company Act of 1935. UniSource Energy
has no significant operations of its own, but owns substantially all of the
common stock of Tucson Electric Power Company (TEP) and all of the common stock
of UniSource Energy Services, Inc. (UES), Millennium Energy Holdings, Inc.
(Millennium) and UniSource Energy Development Company (UED).
TEP, a regulated public utility incorporated in Arizona since 1963, is
UniSource Energy's largest operating subsidiary and represented approximately
84% of UniSource Energy's assets as of December 31, 2004. TEP generates,
transmits and distributes electricity. TEP serves approximately 375,000 retail
electric customers in a 1,155 square mile area in Southern Arizona. TEP also
sells electricity to other utilities and power marketing entities primarily
located in the western U.S.
On August 11, 2003, UniSource Energy completed the purchase of the Arizona
gas and electric system assets from Citizens Communications Company (Citizens)
and established UES to hold such assets. UES' businesses are described in Note
3.
Millennium's unregulated businesses and UED's services are described in
Note 6.
References to "we" and "our" are to UniSource Energy and its subsidiaries,
collectively.
BASIS OF PRESENTATION
We use the following accounting methods to report investments in
subsidiaries or other companies:
o CONSOLIDATION: The consolidation method is used where a majority
of the voting stock of a subsidiary is held and control over the
subsidiary is exercised. The accounts of the subsidiary are
combined with the accounts of the parent and intercompany
balances and transactions are eliminated.
o THE EQUITY METHOD: The equity method is used to report corporate
joint ventures, partnerships, and affiliated company investments
when the ability to exercise significant influence over the
operating and financial policies of an investee company is
demonstrated. The equity method is typically used when 20% to 50%
of the voting interest is held. Under the equity method:
+ The investment appears on a single line item on the balance
sheet; and
+ The net income (loss) from the entity is reflected in Other
Income on the income statements. For investments where UniSource
Energy, TEP, UES or Millennium is committed to providing all of
the financing, they recognize 100% of the losses.
o THE COST METHOD: The cost method is used when not enough shares
are owned to exercise significant influence over an investee
company. Typically the cost method is used for investments of
less than 20% of the voting interest in an investee company.
Under the cost method:
+ The investment appears on a single line item on the balance
sheet; and
+ Income from investee dividend distributions is reflected as Other
Income on the income statements; and
+ Loss is included in Other Income on the income statements when
impairment of the value of the investment is other than
temporary.
USE OF ACCOUNTING ESTIMATES
Management makes estimates and assumptions when preparing financial
statements under accounting principles generally accepted in the United States
of America (GAAP). These estimates and assumptions affect:
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UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
o A portion of the reported amounts of assets and liabilities at
the dates of the financial statements;
o Our disclosures regarding contingent assets and liabilities at
the dates of the financial statements; and
o A portion of the reported revenues and expenses during the
financial statement reporting periods.
Because these estimates involve judgments, the actual amounts may differ
from the estimates.
ACCOUNTING FOR RATE REGULATION
The Arizona Corporation Commission (ACC) and the Federal Energy Regulatory
Commission (FERC) regulate portions of TEP's, UNS Gas' and UNS Electric's
utility accounting practices and rates. The ACC has authority over certain rates
charged to retail customers, the issuance of securities, and transactions with
affiliated parties. The FERC regulates TEP's and UNS Electric's rates for
wholesale power sales and transmission services.
TEP, UNS Gas and UNS Electric generally use the same accounting policies
and practices used by unregulated companies for financial reporting under GAAP.
However, sometimes these principles, such as the Financial Accounting Standards
Board's (FASB) Statement of Financial Accounting Standards No. 71, Accounting
for the Effects of Certain Types of Regulation (FAS 71), require special
accounting treatment for regulated companies to show the effect of regulation.
For example, in setting TEP, UNS Gas and UNS Electric's retail rates, the ACC
may not allow TEP, UNS Gas or UNS Electric to currently charge their customers
to recover certain expenses, but instead may require that these expenses be
charged to customers in the future. In this situation, FAS 71 requires that TEP,
UNS Gas and UNS Electric defer these items and show them as regulatory assets on
the balance sheet until TEP, UNS Gas and UNS Electric are allowed to charge
their customers. TEP, UNS Gas and UNS Electric then amortize these items as
expense to the income statement as these charges are recovered from customers.
Similarly, certain revenue items may be deferred as regulatory liabilities,
which are also eventually amortized to the income statement as rates to
customers are reduced.
The conditions a regulated company must satisfy to apply the accounting
policies and practices of FAS 71 include:
o an independent regulator sets rates;
o the regulator sets the rates to recover specific costs of
delivering service; and
o the service territory lacks competitive pressures to reduce rates
below the rates set by the regulator.
CASH AND CASH EQUIVALENTS
UniSource Energy and TEP define Cash and Cash Equivalents as cash
(unrestricted demand deposits) and all highly liquid investments purchased with
an original maturity of three months or less.
UTILITY PLANT
TEP reports its utility plant on its balance sheets at cost. UES reports
the utility plant of its two operating companies, UNS Gas and UNS Electric, at
cost. Utility plant includes:
o Material and labor costs,
o Contractor costs,
o Construction overhead costs (where applicable), and
o An Allowance for Funds Used During Construction (AFUDC) or
capitalized interest during construction.
AFUDC reflects the cost of financing construction for transmission and
distribution projects with borrowed and equity funds.
TEP imputed the cost of capital on transmission and distribution
construction expenditures at an average of 8.67% in 2004, 8.43% in 2003, and
8.40% in 2002, to reflect the cost of using borrowed and equity funds to finance
construction. The component of AFUDC attributable to borrowed funds is included
as a reduction of Other Interest Expense on the income statement and totaled $1
million in 2004, 2003, and 2002. The equity component is included in Other
Income and totaled $1 million in 2004, 2003, and 2002.
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UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
The interest capitalized during construction of TEP's generation-related
construction projects is included as a reduction of Other Interest Expense on
the income statement and totaled $1 million in 2004, 2003, and $0.5 million in
2002. The average capitalized interest rate during construction applied to
generation-related construction expenditures was 4.33% in 2004, 4.14% in 2003,
and 4.26% in 2002.
For 2004 and the period August 11, 2003 through December 31, 2003, UES
imputed the cost of capital on construction expenditures at an average of 8.73%
for UNS Electric and 7.85% for UNS Gas. The component of AFUDC attributable to
borrowed funds is included as a reduction of Other Interest Expense on the
income statement and totaled $0.5 million in 2004 and $0.2 million in 2003. The
equity component is included in Other Income and totaled $0.5 million in 2004
and $0.2 million in 2003.
DEPRECIATION
TEP and UES compute depreciation for owned utility plant on a
straight-line basis at rates based on the economic lives of the assets. See Note
9. The depreciation rates are approved by the ACC for all plant except TEP's
deregulated generation assets. The depreciable lives for TEP's generation plant
are based on remaining useful lives. Changes made to the depreciable lives of
TEP's generation plant are discussed in Note 9. The depreciation rates for
generation plant reflect interim retirements. Interim retirements of generation
plant, together with removal costs less salvage, are charged to accumulated
depreciation. The costs of planned major maintenance activities are recorded as
the costs are actually incurred and are not accrued in advance of the planned
maintenance. Planned major maintenance activities include the scheduled
overhauls at TEP's generation plants. Minor replacements and repairs are
expensed as incurred.
The depreciable lives for transmission, distribution, general and
intangible plant are based on average lives. The rates reflect estimated removal
costs, net of estimated salvage value for interim retirements. Retirements of
transmission plant, distribution plant, general plant and intangible plant,
together with the cost of removal less salvage, are charged to accumulated
depreciation. Amounts collected through revenues for the net cost of removal of
interim retirements for transmission, distribution, general and intangible plant
which are not yet expended, are reflected as a regulatory liability.
The average annual depreciation rates for TEP's utility plant were 3.80%
in 2004, 3.78% in 2003, and 4.01% in 2002. The average annual depreciation rates
for UES' utility plant in 2004 were 4.38% for UNS Electric and 2.81% for UNS
Gas. The average annualized depreciation rates for UES' utility plant for the
period of August 11, 2003 through December 31, 2003 were 4.25% for UNS Electric
and 2.67% for UNS Gas.
COMPUTER SOFTWARE COSTS
TEP and UES capitalize all costs incurred to purchase computer software
and amortize those costs over the estimated economic life of the product.
Capitalized computer software costs would be immediately charged to expense if
the software is determined to be no longer useful. TEP's amortization of
capitalized computer software costs was $8 million in 2004 and $6 million in
2003 and 2002.
TEP UTILITY PLANT UNDER CAPITAL LEASES
TEP financed the following generation assets with capital leases:
o Springerville Common Facilities,
o Springerville Unit 1,
o Springerville Coal Handling Facilities, and
o Sundt Unit 4.
The following table shows the amount of lease expense incurred for TEP's
generation-related capital leases. We describe the lease terms in TEP Capital
Lease Obligations in Note 10.
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UNISOURCE ENERGY, TEP AND SUBSIDIARIES
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--------------------------------------------------------------------------------
Years Ended December 31,
2004 2003 2002
--------------------------------------------------------------------------------------------------
-Millions of Dollars-
Lease Expense:
Interest Expense on Capital Leases $ 86 $ 84 $ 88
Amortization - Included in:
Operating Expenses - Fuel 4 4 4
Operating Expenses - Depreciation and Amortization 18 25 25
--------------------------------------------------------------------------------------------------
Total Lease Expense $ 108 $ 113 $ 117
==================================================================================================
GLOBAL SOLAR PROPERTIES AND EQUIPMENT
Global Solar's properties and equipment are included, net of accumulated
depreciation, in UniSource Energy's balance sheets in the Investments and Other
Property - Other line item. Properties and equipment are stated at original cost
and are depreciated using the straight-line method over the estimated useful
lives of the assets. Maintenance, repairs and minor renewals are charged to
expense as incurred, while major renewals and betterments are capitalized.
EVALUATION OF ASSETS FOR IMPAIRMENT
TEP, UNS Gas and UNS Electric evaluate their Utility Plant and other
long-lived assets for impairment whenever events or circumstances occur that may
indicate the carrying value of the assets may be impaired. If the fair value of
the asset determined based on the undiscounted expected future cash flows from
the long-lived asset is less than the carrying value of the asset, an impairment
would be recorded.
DEBT
We defer costs related to the issuance of debt. These costs include
underwriters' commissions, discounts or premiums, and other costs such as legal,
accounting and regulatory fees and printing costs. We amortize these costs over
the life of the debt using the straight-line method, which approximates the
effective interest method.
TEP recognizes gains and losses on reacquired debt associated with the
generation portion of its operations as incurred. TEP defers and amortizes the
gains and losses on reacquired debt associated with its regulated operations to
interest income or interest expense over the remaining life of the original
debt.
UTILITY OPERATING REVENUES
TEP and UES record utility operating revenues when services are provided
or commodities are delivered to customers. Operating revenues include unbilled
revenues which are earned (service has been provided) but not billed by the end
of an accounting period.
Unbilled sales are estimated for the month by reviewing the meter reading
schedules and determining the number of billed and unbilled kWhs or therms, as
applicable, for each cycle. Current month estimated unbilled kWhs or therms are
allocated by customer class. New unbilled revenue estimates are recorded and
unbilled revenue estimates from the prior month are reversed.
An Allowance for Doubtful Accounts is recorded as an expense and reduces
accounts receivable for revenue amounts that are estimated to become
uncollectible. TEP and UES establish an allowance for doubtful accounts
receivable based on historical experience and any specific customer collection
issues identified. TEP's Allowance for Doubtful Accounts was $14 million at
December 31, 2004 and $11 million at December 31, 2003. See Note 13 for further
discussion of TEP's wholesale accounts receivable and allowances. UES' Allowance
for Doubtful Accounts was $2 million at December 31, 2004 and $0.4 million at
December 31, 2003.
REVENUE FROM LONG-TERM RESEARCH AND DEVELOPMENT CONTRACTS
UniSource Energy's income statement includes Global Solar's long-term
contract revenue in Other Operating Revenues. Global Solar recognized long-term
contract revenue of less than $1 million in 2004 and just over $1 million in
2003 and 2002. Global Solar and IPS recognized total research and development
expense of $5 million in 2004, $7 million in 2003 and $8 million in 2002. These
expenses include both costs associated with revenue producing contracts and
internal development costs. Global Solar derives much of its revenue from
funding received under research and development contracts with various U.S.
governmental agencies. Revenues on these contracts are recognized as follows:
o COST REIMBURSEMENT CONTRACTS - Revenue is recognized as costs are
incurred;
o COST PLUS FIXED FEE CONTRACTS - Revenues are recognized using the
percentage of completion method of accounting by relating
contract costs incurred to date to total contract costs; and
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o FIXED FEE CONTRACTS - Revenues are recognized when applicable
milestones are met.
Contract costs include direct material, direct labor and overhead costs.
FUEL AND PURCHASED ENERGY COSTS
TEP
Fuel inventory, primarily coal, is recorded at weighted average cost. TEP
uses full absorption costing. Under full absorption costing, all handling and
procurement costs are included in the cost of the inventory. Examples of these
costs are direct material, direct labor and overhead costs. TEP has long-term
contracts for the purchase and transportation of coal with expiration dates from
2006 through 2020. The contracts require TEP to pay a take-or-pay fee if certain
minimum quantities of coal are not purchased or transported. TEP expenses such
fees as they are incurred. TEP recorded minimal take-or-pay fees in 2004 and
less than $1 million of take-or-pay fees in 2003 and 2002. See Purchase and
Transportation Commitments in Note 8, below. Fuel costs include coal mine
reclamation expenses as they are charged to TEP on an ongoing basis.
UES
UNS Gas defers differences between actual gas purchase costs and the
recovery of such costs in revenues under a Purchased Gas Adjustor (PGA)
mechanism. The PGA mechanism is intended to address the volatility of natural
gas prices and allows UNS Gas to recover its costs through a price adjustor. The
PGA charge may be changed monthly based on an ACC approved mechanism that
compares the twelve-month rolling average gas cost to the base cost of gas,
subject to limitations on how much the price per therm may change in a twelve
month period. The difference between the actual cost of UNS Gas' gas supplies
and transportation contracts and that currently allowed by the ACC is deferred
and recovered or repaid through the PGA mechanism. When under or over recovery
trigger points are met, UNS Gas may request a PGA surcharge or surcredit with
the goal of collecting or returning the amount deferred from or to customers
over a twelve month period. UNS Gas had an asset for under recovered purchased
gas costs of $2 million at December 31, 2004 and $3 million at December 31, 2003
that is included in Current Regulatory Assets on UniSource Energy's consolidated
balance sheet.
UNS Electric defers differences between purchased energy costs and the
recovery of such costs in revenues. Future billings are adjusted for such
deferrals through use of a Purchased Power and Fuel Adjustment Clause (PPFAC)
approved by the ACC. The PPFAC allows for a revenue surcharge or surcredit (that
adjusts the customer's base rate for delivered purchased power) to collect or
return under or over recovery of costs. UNS Electric had a liability for over
recovered purchased power costs of $3 million at December 31, 2004 and less than
$1 million at December 31, 2003 that is included in Deferred Credits and Other
Liabilities - Other on UniSource Energy's consolidated balance sheet. See Note
3.
INCOME TAXES
We are required by GAAP to report some of our assets and liabilities
differently for our financial statements than we do for income tax purposes. The
tax effects of differences in these items are reported as deferred income tax
assets or liabilities in our balance sheets. We measure these tax assets and
liabilities using income tax rates that are currently in effect. Federal
Investment Tax Credits (ITC) as well as applicable state income tax credits are
accounted for as a reduction of income tax expense in the year in which the
credit arises.
We allocate income taxes to the subsidiaries based on their taxable income
and deductions as reported in the consolidated and/or combined tax return
filings.
EMISSIONS ALLOWANCES
Emissions Allowances are issued to qualifying utilities by the
Environmental Protection Agency (EPA) based on past operational history. Each
allowance permits emission of one ton of sulfur dioxide (SO2) in its vintage
year or a subsequent year. TEP receives an allotment of these allowances
annually, but UNS Electric doesn't receive any since it has no coal-fired
generation. When issued from the EPA, these allowances have no book value for
accounting purposes but may be sold if TEP does not need them for operations.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
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TEP also may purchase additional allowances if needed. See Note 8. In December
2004, TEP sold 4,000 allowances that were in excess of those required for
compliance to a third party at their fair market value of $3 million. In 2002,
TEP also sold 4,000 excess allowances to Millennium Environmental Group, Inc.
(MEG) at their fair market value of less than $1 million. MEG subsequently sold
these allowances to a third party. The gains from these sales of excess
allowances are reflected as a reduction of Other Operations and Maintenance
expense on TEP's income statement. TEP did not sell any excess allowances in
2003.
DERIVATIVE FINANCIAL INSTRUMENTS
TEP enters into forward contracts to purchase or sell a specified amount
of capacity or energy at a specified price over a given period of time,
typically for one month, three months, or one year, within established limits to
take advantage of favorable market opportunities. The majority of TEP's forward
contracts are considered to be normal purchases and sales and, therefore, are
not required to be marked to market. However, some of these forward contracts
are considered to be derivatives, which TEP marks to market by recording
unrealized gains and losses and adjusting the related assets and liabilities on
a monthly basis to reflect the market prices at the end of the month.
TEP also periodically enters into commodity price swap agreements in an
effort to minimize commodity price risk on its spot market purchases of natural
gas. Under these agreements, TEP purchases gas at fixed prices and
simultaneously sells gas at spot market prices. The swap agreements are
accounted for as cash flow hedges by recording the unrealized gains and losses
in Other Comprehensive Income on the balance sheet and adjusting the related
assets and liabilities on a monthly basis to reflect the market prices at the
end of the month. As the gains and losses on these cash flow hedges are
realized, a reclassification adjustment is recorded in Other Comprehensive
Income for realized gains and losses that are included in Net Income. See Note
7.
UNS Gas and UNS Electric do not currently have any contracts that are
required to be marked to market.
MEG enters into swap agreements, options and forward contracts relating to
Emissions Allowances and coal. MEG marks its trading contracts to market by
recording unrealized gains and losses and adjusting the related assets and
liabilities on a monthly basis to reflect the market prices at the end of the
month.
STOCK-BASED COMPENSATION
At December 31, 2004, UniSource Energy had outstanding awards issued under
two stock-based compensation plans, the 1994 Outside Director Stock Option Plan
(Directors' Plan) and the 1994 Omnibus Stock and Incentive Plan (Omnibus Plan).
See Note 17. Through December 31, 2004, we accounted for those plans under the
recognition and measurement principles of APB Opinion No. 25, Accounting for
Stock Issued to Employees (APB 25), as allowed by Statement of Financial
Accounting Standards No. 123, Accounting for Stock-Based Compensation (FAS 123).
However, management early adopted Statement of Financial Accounting Standards
No. 123R, Share Based Payment effective January 1, 2005. See New Accounting
Standards, below.
Our stock options are granted with an exercise price equal to the market
value of the stock at the date of the grant. Accordingly, no compensation
expense is recorded for these awards. However, compensation expense is
recognized for restricted stock, stock unit, and performance share awards over
the performance/vesting period.
The following table illustrates the effect on UniSource Energy's net
income and earnings per share and TEP's net income had we applied the fair value
recognition provisions of FAS 123 and recognized compensation expense for all
stock-based employee compensation awards:
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UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
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UNISOURCE ENERGY:
----------------
Years Ended December 31,
2004 2003 2002
----------------------------------------------------------------------------------------------------------------------
-Thousands of Dollars-
(except per share data)
Net Income - As Reported $ 45,919 $ 113,941 $ 34,928
Add: Stock-based employee compensation expense included in
reported net income, net of related tax effects 1,535 850 486
Deduct: Total stock-based employee compensation expense
determined under fair value based method for all awards,
net of related tax effects (2,314) (1,840) (1,757)
----------------------------------------------------------------------------------------------------------------------
Pro Forma Net Income $ 45,140 $ 112,951 $ 33,657
======================================================================================================================
Earnings per Share:
Basic - As Reported $ 1.34 $ 3.37 $ 1.04
Basic - Pro Forma $ 1.31 $ 3.34 $ 1.00
Diluted - As Reported $ 1.31 $ 3.32 $ 1.02
Diluted - Pro Forma $ 1.29 $ 3.29 $ 0.98
----------------------------------------------------------------------------------------------------------------------
TEP:
---
Years Ended December 31,
2004 2003 2002
----------------------------------------------------------------------------------------------------------------------
-Thousands of Dollars-
Net Income - As Reported $ 46,127 $ 128,913 $ 55,390
Add: Stock-based employee compensation expense included in
reported net income, net of related tax effects
1,355 787 467
Deduct: Total stock-based employee compensation expense
determined under fair value based method for all awards,
net of related tax effects (2,116) (1,761) (1,725)
----------------------------------------------------------------------------------------------------------------------
Pro Forma Net Income $ 45,366 $ 127,939 $ 54,132
======================================================================================================================
The fair value of each stock option grant is estimated on the date of
grant using the Black-Scholes option-pricing model. There were no stock options
granted during 2004. For the options granted during 2003 and 2002, the following
weighted average assumptions were used:
2003 2002
------------------------------------------------------------------------------------------
Expected life (years) 5 5
Interest rate 2.78% 1.45%
Volatility 23.38% 23.74%
Dividend yield 3.44% 2.83%
Weighted-average grant-date fair value of options granted
during the period $ 2.92 $ 2.90
------------------------------------------------------------------------------------------
NEW ACCOUNTING STANDARDS
The FASB recently issued the following Statements of Financial Accounting
Standards (FAS) and FASB Interpretations (FIN):
o FAS 123(R), Share Based Payment, issued December 2004, requires
all share-based payments to employees, including grants of
employee stock options, to be recognized in the financial
statements based on their grant-date fair values. For public
companies, FAS 123(R) is effective for financial periods
beginning after June 15, 2005. However, management adopted FAS
123(R) effective January 1, 2005. The adoption of FAS 123(R) did
not have a significant impact on our financial statements because
stock options issued under UniSource Energy's Omnibus Plan vested
upon the shareholder vote to approve the proposed acquisition of
UniSource Energy. In addition, the Omnibus Plan expired in
February 2004, and no new stock options can be issued. See Note 2
and Note 17.
o FAS 153, Exchanges of Nonmonetary Assets, issued December 2004,
requires nonmonetary exchanges be accounted for at fair value,
recognizing any gains or losses, if their fair value is
determinable within reasonable limits and the transaction has
commercial substance. A nonmonetary exchange has commercial
substance if future cash flows of the entity are expected to
change significantly as a result of the exchange. FAS 153 is
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UNISOURCE ENERGY, TEP AND SUBSIDIARIES
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effective for nonmonetary asset exchange transactions occurring
in fiscal periods beginning after June 15, 2005. The adoption of
FAS 153 is not expected to have a significant impact on our
financial statements.
o FASB Staff Position (FSP) FAS 109-1, Application of FASB Statement No.
109, Accounting for Income Taxes, to the Tax Deduction on Qualified
Production Activities Provided by the American Jobs Creation Act of
2004, issued in December 2004, provides guidance on the application of
FAS 109 to the provision within the American Jobs Creation Act of 2004
that provides a tax deduction, beginning in 2005, on qualified
production activities, including a company's electric generation
activities. Under FSP FAS 109-1, recognition of the tax deduction on
qualified production activities is ordinarily reported in the year it
is earned. We are evaluating the impact on our financial position and
results of operations from the adoption of FSP FAS 109-1.
o FAS 151, Inventory Costs, issued November 2004, is an amendment
of Accounting Research Bulletin (ARB) No. 43, Chapter 4,
Inventory Pricing. FAS 151 clarifies that abnormal amounts of
idle facility expense, freight, handling costs, and wasted
materials (spoilage) should be recognized as current-period
charges. FAS 151 also requires the allocation of fixed production
overheads to inventory based on the normal capacity of the
production facilities. FAS 151 is effective for inventory costs
incurred during fiscal years beginning after June 15, 2005. The
adoption of FAS 151 is not expected to have a significant impact
on our financial statements.
o FIN 46, Consolidation of Variable Interest Entities, was issued
in January 2003, and was subsequently revised in December 2003
(FIN 46R). The primary objectives of FIN 46R are to provide
guidance on the identification of entities for which control is
achieved through means other than through voting rights (variable
interest entities) and to determine when and which business
enterprises should consolidate the variable interest entity
(primary beneficiary). FIN 46R requires that both the primary
beneficiary and all other enterprises with a significant variable
interest make additional disclosures. For public companies, the
revised FIN 46R is effective for financial periods ending after
March 15, 2004. The adoption of FIN 46R did not have a
significant impact on our financial statements.
See our discussion of FSP 106-2 in Note 16.
In July 2004, the Emerging Issues Task Force (EITF) reached a
consensus on Issue No. 02-14, Whether an Investor Should Apply the Equity Method
of Accounting to Investments Other Than Common Stock (EITF 02-14). EITF 02-14
concludes that an investor that has the ability to exercise significant
influence over the operating and financial policies of an investee should apply
the equity method of accounting only when it has an investment in common stock
or an investment that is in-substance common stock. EITF 02-14 is effective for
reporting periods beginning after September 15, 2004. The adoption of EITF 02-14
did not have a significant impact on our financial statements.
In June 2004, the EITF published Issue No. 03-1, The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain Investments (EITF
03-1). EITF 03-1 provides application guidance on impairment of securities
accounted for under FAS 115, Accounting for Certain Investments in Debt and
Equity Securities, and cost method investments and requires certain quantitative
and qualitative disclosures for securities that are impaired at the balance
sheet date but for which an other-than-temporary impairment has not been
recognized. The disclosure requirements are effective for reporting periods
ending after December 31, 2003. The FASB issued FSP EITF Issue 03-1-1, Effective
Date of Paragraphs 10-20 of EITF Issue No. 03-1, The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain Investments in
September 2004 delaying the effective date of the application guidance on
impairment of securities. The adoption of EITF 03-1 is not expected to have a
significant impact on our financial statements.
In August 2003, the EITF published Issue No. 03-11, Reporting Realized
Gains and Losses on Derivative Instruments That Are Subject to FASB Statement
No. 133, Accounting for Derivative Instruments and Hedging Activities, and Not
"Held for Trading Purposes" as Defined in EITF Issue No. 02-3 (EITF 03-11). EITF
03-11 discusses whether realized gains and losses should be shown gross or net
in the income statement for contracts that are not held for trading purposes, as
defined in EITF 02-3, but are derivatives subject to FAS 133, Accounting for
Derivative Instruments and Hedging Activities. Determining whether realized
gains and losses on derivative contracts not held for trading purposes should be
reported in the income statement on a gross or net basis is a matter of judgment
that depends on the relevant facts and circumstances with respect to the various
activities of the entity. Retroactive application of EITF 03-11 is not required.
Beginning January 1, 2004, the realized gains and losses on derivative
instruments that are not held for trading purposes but are eventually net
settled are shown net in the income statement. The impact of adopting EITF 03-11
was immaterial as of December 31, 2004. See Note 7.
RECLASSIFICATIONS
UniSource Energy and TEP have made reclassifications to the prior year
financial statements and footnotes for comparative purposes. See Note 5 and Note
7. These reclassifications had no effect on Net Income.
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UNISOURCE ENERGY, TEP AND SUBSIDIARIES
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NOTE 2. TERMINATION OF PROPOSED ACQUISITION OF UNISOURCE ENERGY
----------------------------------------------------------------
On November 21, 2003, UniSource Energy and Saguaro Acquisition Corp., a
Delaware corporation, entered into an acquisition agreement, providing for the
acquisition of all of the common stock of UniSource Energy for $25.25 per share
by an affiliate of Saguaro Utility Group L.P., an Arizona limited partnership
(Saguaro Utility), whose general partner is Sage Mountain, L.L.C. and whose
limited partners include investment funds affiliated with Kohlberg Kravis
Roberts & Co., L.P., J.P. Morgan Partners, LLC and Wachovia Capital Partners.
On December 21, 2004, the ACC voted, at the end of a special meeting,
not to approve the application seeking its approval of the proposed acquisition.
On December 30, 2004, Saguaro Utility exercised its right to terminate the
acquisition agreement, and UniSource Energy paid Saguaro Utility $7 million to
cover Saguaro Utility's expenses, pursuant to the terms of the acquisition
agreement. This termination fee, which was expensed as incurred, is included in
Other Operations and Maintenance expense in UniSource Energy and TEP's
Statements of Income and in Other Cash Payments in UniSource Energy and TEP's
Statements of Cash Flows. UniSource Energy allocated $5 million of this
termination fee to TEP with the balance allocated to UNS Gas, UNS Electric, and
Millennium.
UniSource Energy entered into agreements with New Harbor Incorporated
(New Harbor) and Morgan Stanley & Co. Incorporated (Morgan Stanley) in
connection with the acquisition of UniSource Energy by Saguaro Utility.
UniSource Energy expensed $3 million in fees upon announcement of the
transaction in November 2003, which are included in Other Operations and
Maintenance Expense in UniSource Energy's Statements of Income.
LITIGATION CONCERNING THE PROPOSED ACQUISITION AGREEMENT
On August 26, 2004, the Pennsylvania Avenue Event Driven Fund filed a
class action complaint in the Superior Court of the State of Arizona on behalf
of the holders of UniSource Energy Common Stock against UniSource Energy and its
directors (Pennsylvania Ave. Event Driven Fund v. UniSource Energy Corp., et al.
(D. Ariz.)) relating to the proposed acquisition of UniSource Energy by an
affiliate of Saguaro Utility. The plaintiff alleged, among other things, that
members of UniSource Energy's board of directors breached their fiduciary duties
to UniSource Energy's shareholders in connection with the proposed acquisition
by tailoring the acquisition to meet the specific needs of Saguaro Utility and
basing the acquisition on financial results of UniSource Energy that were
subsequently restated to recognize additional net income. The court dismissed
the action in February 2005.
On March 17, 2004, plaintiffs withdrew two shareholder derivative
lawsuits, McBride v. Pignatelli, et al. and Zetooney v. Pignatelli, et al.,
filed in the Superior Court of the State of Arizona on November 24, 2003, the
same day that UniSource Energy announced details of its proposed acquisition by
Saguaro Utility Group, L.P. UniSource Energy paid no consideration in connection
with the withdrawal of the lawsuits. In these two lawsuits, which were virtually
identical, the plaintiffs alleged that UniSource Energy's Board of Directors, in
its consideration and approval of the acquisition agreement, breached its
fiduciary duty to UniSource Energy's shareholders in approving the acquisition
agreement.
NOTE 3. UNISOURCE ENERGY SERVICES
----------------------------------
On August 11, 2003, UniSource Energy acquired the Arizona gas and electric
system assets from Citizens for $223 million, comprised of the base purchase
price plus other operating capital adjustments and transaction costs. This
acquisition added over 132,000 retail gas customers and 85,000 retail electric
customers in Arizona to UniSource Energy's customer base as of December 31,
2004. UniSource Energy formed UNS Gas, Inc. (UNS Gas) and UNS Electric, Inc.
(UNS Electric) to acquire these assets, as well as, UES, to hold the common
stock of UNS Gas and UNS Electric. The operating results of UNS Gas, UNS
Electric, and UES have been included in UniSource Energy's consolidated
financial statements since the acquisition date.
The purchase price and the final allocation of the assets acquired and the
liabilities assumed based on their estimated fair market values as of the
acquisition date are as follows:
K-102
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
PURCHASE PRICE: -Thousands of Dollars-
----------------------------------------------------------------------
Cash Paid $ 218,558
Transaction Costs 4,838
----------------------------------------------------------------------
TOTAL PURCHASE PRICE $ 223,396
======================================================================
ALLOCATION OF PURCHASE PRICE: -Thousands of Dollars-
----------------------------------------------------------------------
Property, Plant & Equipment $ 229,703
Current Assets 31,377
Regulatory Assets 384
Other Assets 580
Long-Term Debt (1,119)
Current Liabilities (31,176)
Deferred Credits and Other Liabilities (6,353)
----------------------------------------------------------------------
TOTAL PURCHASE PRICE $ 223,396
======================================================================
RATES AND REGULATION
Concurrent with the closing of the acquisition, retail rate increases for
customers of both UNS Electric and UNS Gas went into effect on August 11, 2003.
These rate increases were approved by the ACC on July 3, 2003, when it approved
the acquisition and the terms of the April 1, 2003 settlement agreement (UES
Settlement Agreement) among UniSource Energy, Citizens, and the ACC Staff.
UNS GAS
UNS Gas is regulated by the ACC with respect to retail gas rates, the
issuance of securities, and transactions with affiliated parties. UNS Gas'
retail gas rates include a monthly customer charge, a base rate charge for
delivery services and the cost of gas (expressed in cents per therm), and a PGA
mechanism.
The related ACC order and the UES Settlement Agreement include the
following terms related to UNS Gas rates:
o An increase in retail delivery base rates, effective August 11,
2003, equivalent to a 20.9% overall increase over 2001 test year
retail revenues through a base rate increase.
o Fair value rate base of $142 million and allowed rate of return
of 7.49%, based on a cost of capital of 9.05%, derived from a
cost of equity of 11.00% and a cost of debt of 7.75% (based on a
capital structure of 60% debt and 40% equity).
o The existing PGA rate may not change more than $0.15 per therm
through July 2004. Thereafter, the PGA rate may not change more
than $0.10 per therm.
Under the terms of the ACC order, UNS Gas may not file a general rate
increase until August 2006 and any resulting rate increase shall not become
effective prior to August 1, 2007.
The UES Settlement Agreement also limits dividends payable by UNS Gas to
UniSource Energy to 75% of earnings until the ratio of common equity to total
capitalization reaches 40%. The ratio of common equity to total capitalization
for UNS Gas is 37% at December 31, 2004.
In January 2005, UNS Gas requested the ACC approve a PGA surcharge of
$0.06 per therm beginning April 1, 2005 and removed one year later, to recover
its excess gas purchase costs. At December 31, 2004, the PGA bank balance was $9
million. The previous PGA surcharge of $0.1155 per therm took effect October 1,
2003 and ended November 1, 2004.
UNS ELECTRIC
UNS Electric is regulated by the ACC with respect to retail electric
rates, the issuance of securities, and transactions with affiliated parties, and
by the FERC with respect to wholesale power contracts and interstate
transmission service.
K-103
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
The ACC order and UES Settlement Agreement include the following terms
related to UNS Electric rates:
o A 22% overall increase in retail rates effective August 11, 2003
from the rates previously in effect for Citizens. This reflects
the implementation of a PPFAC of $0.01825 per kWh, which combined
with the current base purchased power rate of $0.05194 per kWh,
results in a new PPFAC rate of $0.07019. This allows UNS Electric
to fully recover the cost of purchased power under its current
contract with its sole energy supplier, Pinnacle West Capital
Corporation (PWCC).
o UNS Electric must attempt to renegotiate the PWCC purchase power
contract, and any savings that result from a renegotiated
contract must be allocated in a ratio of 90% to ratepayers and
10% to shareholders.
Under the terms of the ACC order, UNS Electric may not file a general rate
increase until August 2006 and any resulting rate increase shall not become
effective prior to August 1, 2007.
The UES Settlement Agreement also limits dividends payable by UNS Electric
to UniSource Energy to 75% of earnings until the ratio of common equity to total
capitalization reaches 40%. The ratio of common equity to total capitalization
for UNS Electric was 40% at December 31, 2004.
INCOME STATEMENT IMPACT OF APPLYING FAS 71
If UES had not applied FAS 71, net income would have been $4 million
greater in 2004 and $2 million higher in 2003, primarily as a result of the
recovery of deferred purchased power and gas costs.
FUTURE IMPLICATIONS OF DISCONTINUING APPLICATION OF FAS 71
UES' regulatory liabilities exceed its regulatory assets by $4 million at
December 31, 2004. At December 31, 2003, UES' regulatory assets, net of
regulatory liabilities, totaled $1 million. UNS Gas and UNS Electric's
regulatory assets and liabilities are included in rate base and consequently are
earning a return on investment. If UES stopped applying FAS 71 to its regulated
operations, it would write off the related balances of its regulatory assets as
an expense and would write off its regulatory liabilities as income on its
income statement. Based on the regulatory asset and liability balances, if UES
had stopped applying FAS 71 to its regulated operations, it would have recorded
an extraordinary after-tax gain of $2 million at December 31, 2004. UES' cash
flows would not be affected if it stopped applying FAS 71 unless a regulatory
order limited its ability to recover the cost of its regulatory assets.
UES COMMITMENTS
UNS Gas has firm transportation agreements with El Paso Natural Gas (EPNG)
and Transwestern Pipeline Company (Transwestern) with combined capacity
sufficient to meet its load requirements. The EPNG and Transwestern contracts
expire in August 2011 and January 2007, respectively. EPNG provides gas
transportation service under a converted full requirements contract in which UNS
Gas pays a fixed reservation charge. In July 2003, FERC required the conversion
of UNS Gas' full requirements status under the EPNG agreement to contract demand
starting on September 1, 2003. Upon conversion to contract demand status, UNS
Gas now has specific volume limits in each month and specific receipt point
rights from the available supply basins (San Juan and Permian). These changes
will reduce the amount of less expensive San Juan gas available to UNS Gas. The
impact, however, is not expected to be material. The annual cost of the EPNG
capacity after conversion to contract demand will not change through 2005
(pending a 2006 EPNG rate case after which the rates are expected to increase).
UNS Gas made payments under these contracts of $7 million in 2004 and $2 million
from August 11, 2003 through December 31, 2003.
UNS Electric imports the power it purchases over the Western Area Power
Administration's (WAPA) transmission lines. UNS Electric's transmission capacity
agreements with WAPA provide for annual rate adjustments and expire in February
2008 and June 2011. The contract that expires in 2008 also contains a capacity
adjustment clause. UNS Electric made payments under these contracts of $6
million in 2004 and $2 million from August 11, 2003 through December 31, 2003.
K-104
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
At December 31, 2004, UES estimates its future minimum payments under
these contracts to be:
MINIMUM
PURCHASE
OBLIGATIONS
--------------------------------------
-Millions of Dollars-
2005 $ 14
2006 13
2007 10
2008 5
2009 5
-------------------------------------
Total 2005 - 2009 47
Thereafter 7
-------------------------------------
Total $ 54
=====================================
See Note 10 for a description of UES' long-term debt.
UES SUBSEQUENT EVENTS
In January 2005, UNS Gas established a short-term inter-company promissory
note to UniSource Energy, by which it may borrow up to $10 million for general
corporate purposes. This note bears an interest rate of LIBOR plus 2.50% and
expires January 16, 2006. In March 2005, UniSource Energy contributed an
additional $6 million in equity to UNS Gas and an additional $4 million in
equity to UNS Electric, and UNS Gas repaid the $6 million outstanding on this
note from the proceeds of the $6 million equity contribution.
NOTE 4. TEP REGULATORY MATTERS
-------------------------------
Upon approval of the TEP Settlement Agreement in November 1999, TEP
discontinued regulatory accounting under FAS 71 for its generation operations.
TEP continues to report its transmission and distribution operations under FAS
71.
TEP SETTLEMENT AGREEMENT
In November 1999, the ACC approved the TEP Settlement Agreement between
TEP and certain customer groups relating to recovery of TEP's transition costs
and standard retail rates. The TEP Settlement Agreement included:
o Consumer choice: By January 1, 2001, consumer choice for energy
supply was available to all customers.
o No rate increase: TEP's retail rates may not be increased until
December 31, 2008. TEP expects to recover the costs of
transmission and distribution under regulated unbundled rates
both during and after this period.
o Recovery of transition costs: TEP's rates include Fixed and
Floating Competition Transition Charge (CTC) components
designated for the recovery of transition costs, including
generation-related regulatory assets and a portion of TEP's
generation plant assets. Retail rates will decrease by the Fixed
CTC amount after TEP has recovered $450 million or on December
31, 2008, whichever occurs first. The Floating CTC equals retail
rates less the price of retail electric service. The price of
retail electric service includes TEP's transmission and
distribution charge and a market energy component based on a
market index for electric energy. Because TEP's total retail
rates are effectively frozen, the Floating CTC is expected to
allow TEP to recoup the balance of transition recovery assets not
otherwise recovered through the Fixed CTC. The Floating CTC will
end no later than December 31, 2008.
o General rate information: TEP was required to file general rate
information by June 1, 2004, including an updated cost-of-service
study. See Recent Regulatory Action, below.
K-105
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
RECENT COURT ACTION
In January 2005, an Arizona Court of Appeals decision became final in
which the Court held invalid certain portions of the ACC rules on retail
competition and related market pricing. Based on this decision, we cannot
predict what changes, if any, the ACC will make to the Rules and how this
decision might ultimately impact our Settlement Agreement.
2004 GENERAL RATE CASE INFORMATION
On June 1, 2004, as required by the Settlement Agreement, TEP filed
general rate case information with the ACC. TEP's filing does not propose any
change in retail rates, and under the terms of the Settlement Agreement, no rate
case filed by TEP through 2008 may result in a net rate increase. However,
absent the restriction on raising rates, TEP believes that the data in it's
filing would justify an increase in retail rates of 16%.
The general rate case information uses a historical test year ended
December 31, 2003 and establishes, based on TEP's standard offer service, that
TEP is experiencing a revenue deficiency of $111 million. The rate case
information includes, among other things, Springerville Unit 1 costs and other
generation costs including fuel costs in excess of those recovered through
existing rates. The proposed weighted cost of capital for the test year ended
December 31, 2003 is 8.78%, including an 11.5% return on equity (increased from
10.67% currently authorized). The rate case information uses a hypothetical 40%
equity capitalization (excluding capital lease obligations) rather than the
hypothetical 37.5% equity capitalization used in TEP's last general rate case.
TEP's actual equity capitalization (excluding capital lease obligations) at
December 31, 2004 was 27%. In the first half of 2005, TEP expects to increase
common equity to 40% of capitalization (excluding capital lease obligations).
Despite the indicated revenue deficiency, the ACC could conclude that TEP should
decrease rates after June 1, 2005; any such determination would be strongly
opposed by TEP.
A procedural order was issued in February 2005 that outlined how the
review of TEP's general rate case information will proceed. The schedule calls
for staff and intervenor testimony to be filed by June 13, 2005 and hearings, as
appropriate, before the administrative law judge to begin September 12, 2005.
K-106
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
TRANSITION RECOVERY ASSET
TEP's Transition Recovery Asset consists of generation-related regulatory
assets and a portion of TEP's generation plant asset costs. Transition costs
being recovered through the Fixed CTC include: (1) the Transition Recovery
Asset; (2) generation-related plant assets included in Plant in Service on the
balance sheet; and (3) excess capacity deferrals related to operating and
capital costs associated with Springerville Unit 2 which were amortized as an
off-balance sheet regulatory asset through 2003. These transition costs were
amortized as follows:
Years Ended December 31,
2004 2003 2002
---------------------------------------------------------------------------------------------------------------------
-Millions of Dollars-
AMORTIZATION OF TRANSITION COSTS BEING RECOVERED THROUGH THE FIXED CTC:
Transition Costs Being Recovered through the Fixed CTC, beginning of year $ 302 $ 348 $ 384
Amortization of Transition Recovery Asset Recorded on the Income Statement (50) (32) (24)
Amortization of Generation-Related Plant Assets (5) (5) (3)
Amortization of Excess Capacity Deferrals (off-balance sheet) - (9) (9)
---------------------------------------------------------------------------------------------------------------------
TRANSITION COSTS BEING RECOVERED THROUGH THE FIXED CTC, END OF YEAR $ 247 $ 302 $ 348
=====================================================================================================================
The portion of the Transition Recovery Asset that is recorded on the
balance sheet was amortized as follows:
Years Ended December 31,
2004 2003 2002
----------------------------------------------------------------------------------------------------------------
-Millions of Dollars-
AMORTIZATION OF TRANSITION RECOVERY ASSET RECORDED ON THE BALANCE SHEET:
Transition Recovery Asset, beginning of year $ 274 $ 306 $ 330
Amortization of Transition Recovery Asset Recorded on the Income Statement (50) (32) (24)
----------------------------------------------------------------------------------------------------------------
TRANSITION RECOVERY ASSET, END OF YEAR $ 224 $ 274 $ 306
================================================================================================================
The remaining transition costs being recovered through the Fixed CTC
differ from the Transition Recovery Asset recorded on the balance sheet as
follows:
December 31,
2004 2003
--------------------------------------------------------------------------------------------------
-Millions of Dollars-
Transition Costs Being Recovered through the Fixed CTC, end of year $ 247 $ 302
Unamortized Generation-Related Plant Assets (23) (28)
--------------------------------------------------------------------------------------------------
TRANSITION RECOVERY ASSET, END OF YEAR $ 224 $ 274
==================================================================================================
The remaining Transition Recovery Asset balance will be amortized as costs
are recovered through rates until TEP has recovered $450 million of transition
costs or until December 31, 2008, whichever occurs first.
OTHER REGULATORY ASSETS AND LIABILITIES
In addition to the Transition Recovery Asset related to TEP's generation
assets, the following regulatory assets and liabilities are being recovered
through TEP's transmission and distribution businesses:
K-107
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
December 31,
2004 2003
--------------------------------------------------------------------------------
-Millions of Dollars-
OTHER REGULATORY ASSETS
Income Taxes Recoverable through Future Revenues $ 45 $ 50
Current Regulatory Assets 10 9
Other Regulatory Assets 14 12
--------------------------------------------------------------------------------
TOTAL REGULATORY ASSETS $ 69 $ 71
================================================================================
OTHER REGULATORY LIABILITIES
Net Cost of Removal for Interim Retirements $ 67 $ 60
================================================================================
Regulatory assets of approximately $23 million are not presently included
in rate base and consequently are not earning a return on investment. These
regulatory assets are being recovered through cost of service or are authorized
to be collected in future base rates. Current regulatory assets of $10 million
are related to differences between expenses recorded on the accrual basis for
GAAP accounting and on a pay-as-you-go basis for regulatory accounting. The
remaining recovery period generally ranges from 1 to 1.5 years. Regulatory
compliance costs of $11 million require specific rate action and the recovery
period will be determined in the 2004 rate information filing with the ACC. The
remaining $3 million represents unamortized loss on reacquired debt that is not
included in rate base, but the amortization of these costs is included in the
ratemaking calculation of the cost of debt, which is a component of the cost of
capital (rate of return). All regulatory assets are probable of recovery.
See Note 5 for a discussion of the amounts included in Other Regulatory
Liabilities.
INCOME STATEMENT IMPACT OF APPLYING FAS 71
The amortization of TEP's regulatory assets had the following effect on
UniSource Energy's and TEP's income statements:
Years Ended December 31,
2004 2003 2002
-----------------------------------------------------------------------------------
-Millions of Dollars-
OPERATING EXPENSES
Amortization of Transition Recovery Asset $ 50 $ 32 $ 24
INTEREST EXPENSE
Long-Term Debt - - 1
INCOME TAXES 5 7 7
-----------------------------------------------------------------------------------
TOTAL $ 55 $ 39 $ 32
===================================================================================
If TEP had not applied FAS 71 in these years, the above amounts would have
been reflected in the income statements in prior periods. The reclassification
of TEP's generation-related regulatory assets to the Transition Recovery Asset
shortened the amortization period for these assets to nine years.
FUTURE IMPLICATIONS OF DISCONTINUING APPLICATION OF FAS 71
TEP continues to apply FAS 71 to its regulated operations, which include
the transmission and distribution portions of its business. TEP regularly
assesses whether it can continue to apply FAS 71 to these operations. If TEP
stopped applying FAS 71 to its remaining regulated operations, it would write
off the related balances of its regulatory assets as an expense and its
regulatory liabilities as income on its income statement. Based on the
regulatory asset balances, net of regulatory liabilities, at December 31, 2004,
if TEP had stopped applying FAS 71 to its remaining regulated operations, it
would have recorded an extraordinary after-tax loss of approximately $136
million. While regulatory orders and market conditions may affect cash flows,
K-108
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
TEP's cash flows would not be affected if it stopped applying FAS 71 unless a
regulatory order limited its ability to recover the cost of its regulatory
assets.
NOTE 5. ACCOUNTING CHANGE: ACCOUNTING FOR ASSET RETIREMENT OBLIGATIONS
------------------------------------------------------------------------
In June 2001, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards No. 143, Accounting for Asset
Retirement Obligations (FAS 143). It requires entities to record the fair value
of a liability for a legal obligation to retire an asset in the period in which
the liability is incurred. A legal obligation is a liability that a party is
required to settle as a result of an existing or enacted law, statute, ordinance
or contract. When the liability is initially recorded, the entity should
capitalize a cost by increasing the carrying amount of the related long-lived
asset. Over time, the liability is adjusted to its present value by recognizing
accretion expense as an operating expense in the income statement each period,
and the capitalized cost is depreciated over the useful life of the related
asset. Upon settlement of the liability, an entity either settles the obligation
for its recorded amount or incurs a gain or loss if the actual costs differ from
the recorded amount.
Prior to adopting FAS 143, costs for final removal of all owned generation
facilities were accrued as an additional component of depreciation expense.
Under FAS 143, only the costs to remove an asset with legally binding retirement
obligations will be accrued over time through accretion of the asset retirement
obligation and depreciation of the capitalized asset retirement cost.
TEP has identified legal obligations to retire generation plant assets
specified in land leases for its jointly-owned Navajo and Four Corners
Generating Stations. The land on which these stations reside is leased from the
Navajo Nation. The provisions of the leases require the lessees to remove the
facilities upon request of the Navajo Nation at the expiration of the leases.
TEP also has certain environmental obligations at the San Juan Generating
Station (San Juan). TEP has estimated that its share of the cost to remove the
Navajo and Four Corners facilities and to settle the San Juan environmental
obligations will be approximately $38 million at the date of retirement. No
other legal obligations to retire generation plant assets were identified. As of
December 31, 2002, TEP had accrued $113 million for the final decommissioning of
its generating facilities. As discussed below, this amount was reversed for 2002
and included as part of the cumulative effect of accounting change adjustment
when FAS 143 was adopted on January 1, 2003.
On November 12, 2004, TEP, Phelps Dodge Energy Services, LLC and PNM
Resources, Inc. each purchased from Duke Energy North America, LLC a one-third
interest in a limited liability company which owns the partially constructed
natural gas-fired Luna Energy Facility (Luna) in southern New Mexico. Luna is
designed as a 570-MW combined cycle plant and is expected to be operational by
the summer of 2006. The new owners assumed asset retirement obligations to
remove certain piping and evaporation ponds and to restore the ground to its
original condition. TEP has estimated its share to settle the obligations will
be approximately $2 million at the date of retirement.
TEP and UES have various transmission and distribution lines that operate
under land leases and rights of way that contain end dates and restorative
clauses. TEP and UES operate their transmission and distribution systems as if
they will be operated in perpetuity and would continue to be used or sold
without land remediation. As a result, TEP and UES are not recognizing the costs
of final removal of the transmission and distribution lines in their financial
statements. As of December 31, 2004, TEP had accrued $67 million and UES had
accrued $2 million for the net cost of removal for interim retirements from its
transmission, distribution and general plant. As of December 31, 2003, TEP had
accrued $60 million and UES had accrued $0.6 million for these removal costs.
These amounts are reflected in the financial statements as a regulatory
liability.
Upon adoption of FAS 143 on January 1, 2003, TEP recorded an asset
retirement obligation of $38 million at its net present value of $1.1 million,
increased depreciable assets by $0.1 million for asset retirement costs,
reversed $112.8 million of costs previously accrued for final removal from
accumulated depreciation, reversed previously recorded deferred tax assets of
$44.2 million and recognized the cumulative effect of accounting change as a
gain of $111.7 million ($67.5 million net of tax). The adoption of FAS 143 also
resulted in a $6 million reduction of current depreciation expense charged
throughout the year because asset retirement costs are no longer recorded as a
component of depreciation expense.
K-109
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
The following table illustrates on a pro forma basis the amount of the
asset retirement obligation as if FAS 143 had been applied during all periods
presented:
Years Ended December 31,
2004 2003 2002
ACTUAL ACTUAL Pro Forma
----------------------------------------------------------------------------------------------------------------------
-Thousands of Dollars-
Asset Retirement Obligation, beginning of year $ 1,231 $ 1,119 $ 1,017
Accretion Expense 146 112 102
----------------------------------------------------------------------------------------------------------------------
ASSET RETIREMENT OBLIGATION, END OF YEAR $ 1,377 $ 1,231 $ 1,119
======================================================================================================================
The following tables illustrate on a pro forma basis the effect on
UniSource Energy's net income and earnings per share and TEP's net income as if
FAS 143 had been in effect for all income statement periods presented:
UNISOURCE ENERGY:
----------------
Year Ended
December 31, 2002
----------------------------------------------------------------------------------------------
-Thousands of Dollars-
(except per share data)
Net Income - As Reported $ 34,928
Adjustment to accrued expense (net of tax) as if FAS 143
had been applied effective January 1, 2002 3,461
----------------------------------------------------------------------------------------------
PRO FORMA NET INCOME $ 38,389
==============================================================================================
Basic Earnings per Share:
As Reported $ 1.04
Adjustment to accrued expense (net of tax) as if FAS 143
had been applied effective January 1, 2002 0.10
----------------------------------------------------------------------------------------------
PRO FORMA $ 1.14
==============================================================================================
Diluted Earnings per Share:
As Reported $ 1.02
Adjustment to accrued expense (net of tax) as if FAS 143
had been applied effective January 1, 2002 0.10
----------------------------------------------------------------------------------------------
PRO FORMA $ 1.12
==============================================================================================
TEP:
---
Year Ended
December 31, 2002
----------------------------------------------------------------------------------------------
-Thousands of Dollars-
Net Income - As Reported $ 55,390
Adjustment to accrued expense (net of tax) as if FAS 143
had been applied effective January 1, 2002 3,461
----------------------------------------------------------------------------------------------
PRO FORMA NET INCOME $ 58,851
==============================================================================================
Amounts recorded under FAS 143 are subject to various assumptions and
determinations, such as determining whether a legal obligation exists to remove
assets, estimating the fair value of the costs of removal, estimating when final
removal will occur, and the credit-adjusted risk-free interest rates to be used
to discount future liabilities. Changes that may arise over time with regard to
these assumptions and determinations will change amounts recorded in the future
as expense for asset retirement obligations.
K-110
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
If TEP retires any asset at the end of its useful life, without a legal
obligation to do so, it will record retirement costs at that time as incurred or
accrued. TEP does not believe that the adoption of FAS 143 will result in any
change in retail rates since all matters relating to the rate-making treatment
of TEP's generating assets were determined pursuant to the TEP Settlement
Agreement.
NOTE 6. SEGMENT AND RELATED INFORMATION
----------------------------------------
Based on the way we organize our operations and evaluate performance, we
have four reportable segments:
(1) TEP, a vertically integrated electric utility business, is
UniSource Energy's largest subsidiary.
(2) UNS Gas is a regulated gas distribution business. Results from
UNS Gas are for the period from August 11, 2003 through December
31, 2004 only (see Notes 1 and 3).
(3) UNS Electric is a regulated electric distribution utility
business. Results from UNS Electric are also for the period from
August 11, 2003 through December 31, 2004 only (see Notes 1 and
3).
(4) Global Solar, a developer and manufacturer of light-weight
thin-film photovoltaic cells and panels, is the largest
investment held by Millennium.
The UniSource Energy, UES and Millennium holding companies, UED, and
several other subsidiaries and equity investments, which are not considered
reportable segments, are included in All Other. Through affiliates, Millennium
holds investments in several unregulated energy and emerging technology
companies. UED, a wholly-owned subsidiary of UniSource Energy, developed
generating resources and performed other project development activities,
including the expansion of the Springerville Generating Station.
Significant revenues and expenses included in All Other include the
following:
o In 2004, Millennium recorded its share of income and losses
related to gains and losses on sales of investments by its
investees.
o In 2004, UED recognized an impairment loss on the entire $2
million balance of a note receivable.
o In 2003, UED received a development fee (including accrued
interest on development funds advanced) of $11 million in
connection with expansion of the Springerville Generating
Station. See Note 14.
Our reportable segments have changed from the segments reported in prior
years. We have reclassified information for earlier periods to conform to the
current year's presentation.
Significant reconciling adjustments consist of the elimination of
intercompany activity and balances. Global Solar recorded revenue from
transactions with TEP of $4 million, $8 million and $7 million in 2004, 2003 and
2002, respectively. Millennium's other subsidiaries also recorded revenue from
transactions with TEP of $13 million, $8 million and $8 million in 2004, 2003
and 2002, respectively. TEP's related expense is reported in Other Operations
and Maintenance expense on its income statement. Global Solar's and Millennium's
revenue and TEP's related expense are eliminated in UniSource Energy
consolidation. Other significant reconciling adjustments include the elimination
of investments in subsidiaries held by UniSource Energy, the intercompany note
between UniSource Energy and TEP, the related interest income and expense on the
note, reclassifications of deferred tax assets and liabilities, and the
elimination of UED's rental income and TEP's rental expense resulting from UED's
turbine lease to TEP prior to UED's sale of the turbine to TEP in September
2002.
As discussed in Note 1, we record our percentage share of the earnings of
affiliated companies when we hold a 20% to 50% voting interest, except for
investments where we provide all of the financing, in which case we recognize
100% of the losses. Our portion of the net income (loss) of the entities in
which TEP and Millennium own a 20-50% interest or have the ability to exercise
significant influence is shown below in Net Income (Loss) from Equity Method
Entities.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
We disclose selected financial data for our reportable segments in the
following tables:
REPORTABLE SEGMENTS
------------------------------------ UNISOURCE
UNS UNS GLOBAL ALL RECONCILING ENERGY
2004 TEP GAS ELECTRIC SOLAR OTHER ADJUSTMENTS CONSOLIDATED
----------------------------------------------------------------------------------------------------------------------------------
INCOME STATEMENT -Millions of Dollars-
----------------
Operating Revenues - External $ 887 $ 129 $ 144 $ 5 $ 4 $ - $ 1,169
Operating Revenues - Intersegment 2 - - 4 14 (20) -
Depreciation and Amortization 117 5 9 3 1 - 135
Amortization of Transition Recovery
Asset 50 - - - - - 50
Interest Income 29 - - - - (9) 20
Net Income from Equity Method Entities - - - - 6 - 6
Interest Expense 157 6 5 - 9 (9) 168
Income Tax Expense (Benefit) 35 4 3 (4) (4) - 34
Net Income (Loss) 46 6 4 (5) (5) - 46
----------------------------------------------------------------------------------------------------------------------------------
CASH FLOW STATEMENT
-------------------
Net Cash Flows - Operating Activities 275 21 19 (10) 7 (5) 307
Net Cash Flows - Investing Activities -
Capital Expenditures (116) (19) (19) - - 1 (153)
Net Cash Flows - Investing Activities -
Investments in and Loans to Equity
Method Entities - - - - (4) - (4)
Net Cash Flows - Investing Activities -
Other (10) - - - 11 - 1
Net Cash Flows - Financing Activities (101) (1) (2) 9 (7) 4 (98)
----------------------------------------------------------------------------------------------------------------------------------
BALANCE SHEET
-------------
Total Assets 2,742 201 135 20 930 (852) 3,176
Investments in Equity Method Entities 2 - - - 34 - 36
----------------------------------------------------------------------------------------------------------------------------------
2003
----------------------------------------------------------------------------------------------------------------------------------
INCOME STATEMENT
----------------
Operating Revenues - External $ 851 $ 47 $ 56 $ 2 $ 17 $ - $ 973
Operating Revenues - Intersegment 1 - - 8 9 (18) -
Depreciation and Amortization 121 2 3 3 2 - 131
Amortization of Transition Recovery
Asset 32 - - - - - 32
Interest Income 31 - - - - (11) 20
Net Loss from Equity Method Entities - - - - (3) - (3)
Interest Expense 161 2 2 1 12 (11) 167
Income Tax Expense (Benefit) 21 1 1 (5) (6) - 12
Net Income (Loss) 129 1 2 (7) (11) - 114
----------------------------------------------------------------------------------------------------------------------------------
CASH FLOW STATEMENT
-------------------
Net Cash Flows - Operating Activities 261 5 8 (13) 2 - 263
Net Cash Flows - Investing Activities -
Capital Expenditures (122) (9) (5) (2) 1 - (137)
Net Cash Flows - Investing Activities -
Investments in and Loans to Equity
Method Entities - - - - (2) - (2)
Net Cash Flows - Investing Activities -
Other 11 (137) (84) - (2) - (212)
Net Cash Flows - Financing Activities (141) 149 93 16 (19) - 98
----------------------------------------------------------------------------------------------------------------------------------
BALANCE SHEET
-------------
Total Assets 2,767 185 125 26 845 (825) 3,123
Investments in Equity Method Entities 5 - - - 31 - 36
----------------------------------------------------------------------------------------------------------------------------------
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UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------------------------------------
2002
----------------------------------------------------------------------------------------------------------------------------------
INCOME STATEMENT
----------------
Operating Revenues - External $ 834 $ - $ - $ 1 $ 5 $ - $ 840
Operating Revenues - Intersegment - - - 7 10 (17) -
Depreciation and Amortization 124 - - 3 1 - 128
Amortization of Transition Recovery
Asset 24 - - - - - 24
Interest Income 29 - - - 1 (9) 21
Net Loss from Equity Method Entities (1) - - - (3) - (4)
Interest Expense 154 - - - 10 (9) 155
Income Tax Expense (Benefit) 36 - - (1) (17) - 18
Net Income (Loss) 55 - - (14) (6) - 35
----------------------------------------------------------------------------------------------------------------------------------
CASH FLOW STATEMENT
-------------------
Net Cash Flows - Operating Activities 207 - - (10) (21) - 176
Net Cash Flows - Investing Activities -
Capital Expenditures (103) - - (9) (1) - (113)
Net Cash Flows - Investing Activities -
Purchase of North Loop Gas Turbine
from UED (15) - - - 15 - -
Net Cash Flows - Investing Activities -
Investments in and Loans to Equity
Method Entities - - - - (24) - (24)
Net Cash Flows - Investing Activities -
Other (136) - - - 1 - (135)
Net Cash Flows - Financing Activities (57) - - 18 (4) - (43)
----------------------------------------------------------------------------------------------------------------------------------
BALANCE SHEET
-------------
Total Assets 2,809 - - 22 797 (742) 2,886
Investments in Equity Method Entities 6 - - - 35 - 41
----------------------------------------------------------------------------------------------------------------------------------
NOTE 7. ACCOUNTING FOR DERIVATIVE INSTRUMENTS, TRADING ACTIVITIES AND HEDGING
------------------------------------------------------------------------------
ACTIVITIES
----------
TEP enters into forward contracts to purchase or sell a specified amount
of capacity or energy at a specified price over a given period of time,
typically for one month, three months, or one year, within established limits to
take advantage of favorable market opportunities. In general, TEP enters into
forward purchase contracts when market conditions provide the opportunity to
purchase energy for its load at prices that are below the marginal cost of its
supply resources or to supplement its own resources (e.g., during plant outages
and summer peaking periods). TEP enters into forward sales contracts when it
forecasts that it has excess supply and the market price of energy exceeds its
marginal cost. The majority of TEP's forward contracts are considered to be
normal purchases and sales and, therefore, are not required to be marked to
market. However, some of these forward contracts are considered to be
derivatives, which TEP marks to market by recording unrealized gains and losses
and adjusting the related assets and liabilities on a monthly basis to reflect
the market prices at the end of the month.
TEP has a natural gas supply agreement under which it purchases all of its
gas requirements at spot market prices from Southwest Gas Corporation (SWG). TEP
also has agreements to purchase power that are priced using spot market gas
prices. These contracts meet the definition of normal purchases and are not
required to be marked to market. During 2004 and early 2005, in an effort to
minimize price risk on these purchases, TEP entered into commodity price swap
agreements under which TEP purchases gas at fixed prices and simultaneously
sells gas at spot market prices. The spot market price in the swap agreements is
tied to the same index as the purchases under the SWG and purchased power
contracts. These swap agreements, which expire during the summer months through
2007, were entered into with the goal of locking in fixed prices on at least 45%
and not more than 80% of TEP's expected summer monthly gas risk prior to
entering into the month. The swap agreements entered into in 2004 are accounted
for as cash flow hedges in the financial statements as of December 31, 2004.
TEP's swap agreements are marked to market on a monthly basis; however, since
the agreements satisfy the requirements for cash flow hedge accounting, the
unrealized gains and losses are recorded in Other Comprehensive Income, a
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
component of Common Stock Equity, rather than being reflected in the income
statement. As the gains and losses on these cash flow hedges are realized, a
reclassification adjustment is recorded in Other Comprehensive Income for
realized gains and losses that are included in Net Income. At December 31, 2003,
TEP had no such material cash flow hedges.
TEP manages the risk of counterparty default by performing financial
credit reviews, setting limits, monitoring exposures, requiring collateral when
needed, and using a standardized agreement which allows for the netting of
current period exposures to and from a single counterparty.
UNS Gas and UNS Electric do not currently have any contracts that are
required to be marked to market. UNS Gas does have a natural gas supply and
management agreement under which it purchases substantially all of its gas
requirements at market prices from BP Energy Company (BP). However, the contract
terms allow UNS Gas to lock in fixed prices on a portion of its gas purchases by
entering into fixed price forward contracts with BP at various times during the
year. This enables UNS Gas to provide more stable prices to its customers. These
purchases are made up to three years in advance with the goal of locking in
fixed prices on at least 45% and not more than 80% of the expected monthly gas
consumption prior to entering into the month. These forward contracts, as well
as the main gas supply contract, meet the definition of normal purchases and
therefore are not required to be marked to market.
MEG, a wholly-owned subsidiary of Millennium, enters into swap agreements,
options and forward contracts relating to Emissions Allowances and coal. MEG
marks its trading contracts to market by recording unrealized gains and losses
and adjusting the related assets and liabilities on a monthly basis to reflect
the market prices at the end of the month.
The market prices used to determine fair values for TEP and MEG's
derivative instruments are estimated based on various factors including broker
quotes, exchange prices, over the counter prices and time value.
TEP and MEG's derivative activities are reported as follows:
INCOME STATEMENT LINE
-------------------------------------------------------------------------------------------------
NET UNREALIZED GAINS NET REALIZED GAINS
AND LOSSES AND LOSSES
-------------------------------------------------------------------------------------------------
TEP Forward Sales Contracts Electric Wholesale Sales Electric Wholesale Sales
TEP Forward Purchase Contracts Purchased Power Purchased Power
TEP Commodity Price Swaps Other Comprehensive Income Fuel Expense
(Balance Sheet)
MEG Trading Activities Other Operating Revenues Other Operating Revenues
-------------------------------------------------------------------------------------------------
Although MEG's realized gains and losses on trading activities are reported
net on UniSource Energy's income statement, the related cash receipts and cash
payments are reported separately on UniSource Energy's statement of cash flows.
The net pre-tax gains and losses from TEP and MEG's derivative activities
were as follows:
Years Ended December 31,
2004 2003 2002
--------------------------------------------------------------------------------
-Millions of Dollars-
TEP:
Net Unrealized Gain (Loss)
on Forward Sales Contracts $ 1.5 $(0.8) $(1.3)
Net Unrealized Gain (Loss)
on Forward Purchase Contracts (0.2) 0.4 1.8
Net Unrealized Gain on Commodity
Price Swaps 2.6 - -
Net Realized Loss on Commodity
Price Swaps (0.2) - -
MEG:
Net Gain from Trading Activities 1.3 0.6 0.1
--------------------------------------------------------------------------------
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--------------------------------------------------------------------------------
TEP and MEG's derivative assets and liabilities are reported as
follows:
BALANCE SHEET LINE
----------------------------------------------------
ASSETS LIABILITIES
--------------------------------------------------------------------------------
TEP - Current Other Current Assets Other Current Liabilities
TEP - Noncurrent Other Assets Other Liabilities
MEG - Current (including
Emissions Allowance
Inventory) Trading Assets Trading Liabilities
MEG - Noncurrent Other Assets Other Liabilities
--------------------------------------------------------------------------------
The fair value of TEP and MEG's derivative assets and liabilities were as
follows:
December 31,
2004 2003
--------------------------------------------------------------------------------
-Millions of Dollars-
TEP:
Derivative Assets - Current $ 2.3 $ 0.4
Derivative Assets - Noncurrent 1.3 -
Derivative Liabilities - Current (0.1) (0.8)
MEG:
Trading Assets - Current 71.0 20.0
Trading Assets - Noncurrent 5.5 1.5
Trading Liabilities - Current (65.0) (18.2)
Trading Liabilities - Noncurrent - (0.5)
--------------------------------------------------------------------------------
Beginning January 1, 2004, the settlement of forward purchase and sales
contracts that do not result in physical delivery are recorded net as a
component of Electric Wholesale Sales in TEP's income statement. During 2004, $5
million in sales were netted against $5 million in purchases.
In accordance with UniSource Energy's intention to cease making capital
contributions to Millennium, Millennium has significantly reduced the holdings
and activity of MEG. MEG is in the process of winding down its activities and
will not engage in any new activities after 2005. As of January 31, 2005, the
fair value of MEG's trading assets was $62 million and the fair value of MEG's
trading liabilities was $56 million.
NOTE 8. COMMITMENTS AND CONTINGENCIES
--------------------------------------
TEP COMMITMENTS
PURCHASE AND TRANSPORTATION COMMITMENTS
In 2003, the ACC issued the Track B Order which defined the competitive
bidding process TEP must use to obtain capacity and energy requirements beyond
what is supplied by TEP's existing resources for the period 2003 through 2006.
TEP estimated this to be approximately 0.5% of its retail load in the first year
and gradually increasing over the period. This order further required TEP to bid
out short-term energy purchases that it estimated it will make in the 2003 to
2006 period. The order does not require TEP to purchase any power that it deems
to be uneconomical, unreasonable or unreliable. The Track B Order did not
address TEP's purchased power or asset acquisitions occurring subsequent to the
2003 competitive solicitation. In 2003, TEP entered into two power purchase
agreements for the period 2003 through 2006 as listed below:
o PPL Energy Plus, LLC supplied 37 MW from June 2003 through
December 2003 and supplies 75 MW from January 2004 through
December 2006, under a unit contingent contract.
o Panda Gila River generating station supplies 50 MW on-peak from
June through September, from 2003 through 2005, under a unit
contingent contract between TEP and Panda Gila River, L.P.
These purchases are intended to provide adequate reserve margins during
the summer peak period. TEP made payments under these contracts of $14 million
in 2004 and $8 million in 2003.
TEP has several long-term contracts for the purchase and transportation of
coal with expiration dates from 2006 through 2020. The total amount paid under
these contracts depends on the number of tons of coal purchased and transported.
All of these contracts (i) include a price adjustment clause that will affect
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UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
the future cost of coal and (ii) require TEP to pay a take-or-pay charge or
liquidated damages if certain minimum quantities of coal are not purchased
and/or transported. TEP's present fuel requirements are in excess of the
take-or-pay minimums. At times, TEP has purchased coal from other suppliers,
resulting in take-or-pay minimum charges, but a lower overall cost of fuel. TEP
made payments under these contracts of $175 million in 2004, $167 million in
2003, and $161 million in 2002.
TEP has a Gas Procurement Agreement with Southwest Gas Corporation that
expires in June 2006. The contract has minimum volume obligations. TEP used more
gas than this minimum requirement in 2004 and expects to use more than the
minimum in 2005. In the event TEP purchases fewer MMBtus, TEP is obligated to
pay only the transportation component for any shortfall. TEP made total payments
for commodity and transportation under this contract of $34 million in 2004 and
2003, and $33 million in 2002.
At December 31, 2004, TEP estimates that future minimum payments under the
contracts for purchased power, coal, and gas referred to above are as follows:
MINIMUM
PURCHASE
OBLIGATIONS
------------------------------------------------------
-Millions of Dollars-
2005 $ 96
2006 90
2007 79
2008 79
2009 79
------------------------------------------------------
Total 2005 - 2009 423
Thereafter 357
------------------------------------------------------
Total $ 780
======================================================
OPERATING LEASES
TEP, Millennium, UES and UED have entered into operating leases, primarily
for office facilities and computer equipment, with varying terms, provisions,
and expiration dates. UniSource Energy's consolidated operating lease expense
was $3 million in each of 2004, 2003, and 2002. TEP's operating lease expense
was $1 million in 2004 and $2 million in each of 2003 and 2002. UniSource Energy
and TEP's estimated future minimum payments under non-cancelable operating
leases at December 31, 2004 are as follows:
UNISOURCE
ENERGY
CONSOLIDATED TEP
-------------------------------------------------
-Millions of Dollars-
2005 $ 2 $ 1
2006 2 1
2007 2 1
2008 2 1
2009 1 1
-------------------------------------------------
Total 2005 - 2009 9 5
Thereafter 4 1
-------------------------------------------------
Total $13 $ 6
=================================================
ENVIRONMENTAL REGULATION
The 1990 Federal Clean Air Act Amendments call for reductions of SO2 and
nitrogen oxide (NOx) emissions in two phases. TEP is subject only to Phase II of
the SO2 and NOx emissions reductions which was effective January 1, 2000. All of
TEP's generating facilities (except existing internal combustion turbines) are
affected. TEP capitalized $9 million in 2004, $11 million in 2003 and $8 million
in 2002 in construction costs to comply with environmental requirements and
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--------------------------------------------------------------------------------
expects to capitalize $1 million in 2005 and $2 million in 2006. These amounts
exclude the upgraded emissions control equipment at the Springerville Generating
Station that will be paid for by the Unit 3 project and recorded at zero basis
by TEP. See Note 14. In addition, TEP recorded expenses of $9 million in 2004,
$8 million in 2003, and $6 million in 2002 related to environmental compliance,
including the cost of lime used to scrub the stacks. TEP expects environmental
expenses to be $8 million in 2005 and 2006.
In 1993, TEP's generating units affected by Phase II were allocated SO2
Emissions Allowances based on past operational history. Beginning in the year
2000, Phase II generating units were required to hold Emissions Allowances equal
to the level of emissions in the compliance year or pay penalties and offset
excess emissions in future years. TEP had sufficient Emissions Allowances to
comply with the Phase II SO2 regulations for compliance year 2004. However, due
to potential changes in the legislation affecting SO2 Emission Allowances
allocation, TEP may have to purchase additional Emissions Allowances for future
compliance years 2010 or beyond.
The EPA has issued a determination that coal and oil-fired electric
utility steam generating units must control their mercury emissions. On March
15, 2005, the EPA adopted regulations relating to mercury emissions under
Section 111 of the Clean Air Act. Additional rule-making procedures will take
place at the state level prior to implementation of the new regulations. TEP is
analyzing the potential impact of the regulations on its operations. Until these
state procedures are adopted, TEP can not determine if it will be significantly
affected. If TEP is not allocated sufficient allowances for its current
emissions, it may have to purchase additional allowances on the market, or
implement additional controls to reduce emissions.
INCOME TAX ASSESSMENTS
In 2004, the Company settled the audit of state income tax returns for the
period 1990 - 2000 with the Arizona Department of Revenue. As a result,
UniSource Energy and TEP recorded $1 million of income. Expense of $1 million
had been recorded at TEP and Nations Energy in 2003 when the preliminary audit
report was received. No additional tax assessments were levied in 2004.
In 2002, the Company settled an IRS audit for 1997-2000, and after
reviewing the impact of the audit findings as well as the effect of tax
positions established in relation to future tax years, TEP reversed $1 million
of the deferred tax valuation allowance. See Note 15.
SALES TAX ASSESSMENTS
In 2004, the City of Tucson issued its assessment for the 1998 - 2001
sales tax audit. After reviewing the audit findings, as well as assessing their
impact on years subsequent to the audit period, TEP recorded a combined $1
million of sales tax and interest expense.
TUCSON TO NOGALES TRANSMISSION LINE
In January 2001, TEP and Citizens (now UES) entered into a project
development agreement for the joint construction of a 62-mile transmission line
from Tucson to Nogales, Arizona. This project was initiated by Citizens (now
UES) in response to an order by the ACC to improve reliability to its retail
customers in Nogales, Arizona. TEP is currently seeking approvals for the
project from the ACC, the Department of Energy (DOE), the U.S. Forest Service,
the U.S. Bureau of Land Management, and the International Boundary and Water
Commission. Through December 31, 2004, approximately $10 million in land
acquisition, engineering and environmental expenses have been capitalized
related to this project. If TEP does not receive the required approvals, it may
be required to expense $8 million of costs that have been capitalized related to
the project.
RESOLUTION OF TEP COMMITMENTS
SUNDT COAL CONTRACT TERMINATION
In the third quarter of 2002, TEP terminated a coal supply agreement for
the Sundt Generating Station. As a result, TEP recorded a pre-tax charge of $11
million and made an $11 million payment in the third quarter of 2002. The
additional expense was mitigated by TEP not being required to make a take-or-pay
penalty payment of approximately $3 million for the year 2002 and subsequent
years.
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UNISOURCE ENERGY, TEP AND SUBSIDIARIES
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--------------------------------------------------------------------------------
UES COMMITMENTS
See Note 3 for a description of UES' commitments.
MILLENNIUM COMMITMENTS
Millennium has been authorized to fund its subsidiaries up to an additional
$15 million for capital and operations out of its existing cash or returns from
its investments. Millennium may commit to provide additional funding to its
investments in the future. In addition, at December 31, 2004, Global Solar has
commitments to incur $1 million of expenses related to government contracts.
TEP CONTINGENCIES
SPRINGERVILLE GENERATING STATION COMPLAINT
Environmental activist groups have expressed concerns regarding the
construction of any new units at the Springerville Generating Station. In
January 2003, environmental activist groups appealed an ACC Order affirming the
ACC's approval of the expansion at the Springerville Generating Station to the
Superior Court of the State of Arizona. On October 22, 2003, the Superior Court
affirmed the ACC's issuance of the Certificate of Environmental Compatibility
for Springerville Generating Station. The environmental activist groups appealed
the Superior Court decision on December 30, 2003 and filed an amended notice of
appeal on January 2, 2004 with the Arizona Court of Appeals. In February 2005,
the Arizona Court of Appeals upheld the lower court's ruling affirming the ACC's
approval of the expansion at Springerville Generating Station. The Grand Canyon
Trust (GCT), one of the environmental activist groups associated with this
appeal, agreed to resolve this claim against TEP. See Resolution of TEP
Contingencies below. The other environmental activist group has 30 days to
petition the Arizona Supreme Court for review.
LITIGATION AND CLAIMS RELATED TO SAN JUAN GENERATING STATION
The EPA has listed San Juan as a potential damage case pursuant to the
Resource Conservation and Recovery Act due to claims by third parties that the
San Juan Generating Station has contaminated water resources in the region as a
result of disposing of fly ash in the surface mine pits adjacent to the
generating station. PNM and the coal supplier to San Juan vigorously deny these
allegations. The EPA is investigating the claims.
LITIGATION AND CLAIMS RELATED TO NAVAJO GENERATING STATION
On October 15, 2004, Peabody Western Coal Company (Peabody), the coal
suppler to the Navajo Generating Station, filed a complaint in the Circuit Court
for the City of St. Louis, Missouri against the participants at Navajo,
including TEP, for reimbursement of royalties and other costs and breach of the
coal supply agreement. Because TEP only owns 7.5% of the Navajo Generating
Station, its share of the current claimed damages would be approximately $35
million. TEP believes these claims are without merit and intends to continue to
contest them.
POSTRETIREMENT AND PENSION BENEFIT COSTS AT VARIOUS GENERATING STATIONS
The coal suppliers to Springerville Generating Station and some of TEP's
remote generating stations have submitted demands for payment by TEP of
postretirement and pension benefit costs for these coal suppliers' employees
under the coal supply agreements with TEP.
Springerville Generating Station: In June 2004, TEP paid $3 million in
settlement of a claim for postretirement benefit costs related to the coal
supply agreement at Springerville Generating Station. In addition, a clause was
deleted from the coal supply agreement that would have allowed costs related to
increases in welfare and pension benefits resulting from attempts to unionize or
union negotiations to be passed to TEP. TEP recorded costs of $0.5 million in
2003 and 2004 associated with the settlement for the period April 2002 through
June 2004. The remaining settlement of $2 million represents a prepayment and
will be amortized to coal inventory over the remaining life of the coal supply
agreement through 2010 and expensed as fuel is burned.
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UNISOURCE ENERGY, TEP AND SUBSIDIARIES
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--------------------------------------------------------------------------------
Four Corners Generating Station: The claim for postretirement benefits at
Four Corners was settled as part of the coal contract extension. TEP paid $0.3
million for postretirement benefits in 2003.
Navajo Generating Station: Peabody has filed a lawsuit against the
participants at Navajo, including TEP, for retiree postretirement benefit costs.
The Navajo participants and Peabody have agreed to stay the discovery process in
this litigation until August 31, 2005 to allow the parties additional time to
negotiate a potential settlement.
San Juan Generating Station: The cost of postretirement benefits is
included in the cost of coal to San Juan.
To the extent that amounts become estimatable and payment probable, TEP
will record a liability for additional postretirement and pension benefit costs
at the Navajo Generating Station. TEP does not expect any settlement to be
material to TEP.
ENVIRONMENTAL RECLAMATION AT REMOTE GENERATING STATIONS
TEP currently pays on-going reclamation costs related to the coal mines
which supply the remote generating stations, and it is probable that TEP will
have to pay a portion of final reclamation costs upon mine closure. When a
reasonable estimate of final reclamation costs is available, the liability is
recognized as a cost of coal over the remaining term of the respective coal
supply agreement. At December 31, 2004, TEP estimates its undiscounted final
reclamation liability to be $42 million, and the present value of TEP's
liability for final reclamation approximates $12 million at the expiration dates
of the coal supply agreements.
Amounts recorded for final reclamation are subject to various assumptions
and determinations, such as estimating the costs of reclamation, estimating when
final reclamation will occur, and the credit-adjusted risk-free interest rate to
be used to discount future liabilities. Changes that may arise over time with
regard to these assumptions and determinations will change amounts recorded in
the future as expense for post-term reclamation. TEP does not believe that
recognition of its final reclamation obligations will be material to TEP in any
single year since recognition occurs over the remaining lives of its coal supply
agreements.
RESOLUTION OF TEP CONTINGENCY
GRAND CANYON TRUST
In November 2001, GCT filed a complaint in U.S. District Court against TEP
for alleged violations of the Clean Air Act at the Springerville Generating
Station. The complaint alleged that more stringent emission standards should
apply to Units 1 and 2. In February 2005, TEP and the GCT reached a settlement
under which the GCT will resolve all claims against TEP regarding Springerville
Generating Station. TEP will implement new emission limits at Units 1 and 2 by
January 1, 2006, and, if SRP decides to construct Unit 4 (see Note 14), $1
million will be contributed for each of five years to a demand side management
fund. This settlement is not expected to be material to TEP.
LITIGATION AND CLAIMS RELATED TO SAN JUAN GENERATING STATION
On May 16, 2002, the GCT and the Sierra Club filed a citizen lawsuit under
the Clean Air Act in federal district court in New Mexico against Public Service
Company of New Mexico (PNM) as operator of San Juan. TEP owns 50% of San Juan
Units 1 and 2, which equates to 19.8% of the total San Juan Generating Station.
The lawsuit alleges two violations of the Clean Air Act and related regulations
and permits. One of the two claims, concerning the initial permitting of San
Juan, was dismissed by the court in August 2003. The remaining claim alleged
that PNM violated its present Title V operating permit for Units 1, 3 and 4 by
exceeding the 20% opacity standard on numerous occasions between 1998 and 2002;
opacity is a means to monitor the particulate matter contained in an emission.
In September 2003, the New Mexico Environment Department (NMED) notified
PNM, operator of San Juan, of alleged excess emissions and opacity in violation
of the air quality permits at San Juan. The NMED issued a draft compliance order
assessing unspecified civil penalties; however, no compliance order has been
issued.
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UNISOURCE ENERGY, TEP AND SUBSIDIARIES
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--------------------------------------------------------------------------------
PNM has reached a settlement agreement with the parties that will cause the
above-described actions to be dismissed. Under the agreement, the co-owners of
San Juan will install new technology at the generating station to reduce
mercury, particulate matter, NOx, and SO2 emissions over the next five years.
TEP's share of the cost of new pollution control equipment based on its
ownership of San Juan is anticipated to be approximately $25 million. The
majority of those capital expenditures will be incurred in calendar years 2007,
2008, and 2009. In addition, TEP's share of increased operating and maintenance
costs associated with the new technologies is expected to be approximately $12
million over the next 10 years.
UES CONTINGENCY
See Note 3 for a description of UES' contingency.
MILLENNIUM CONTINGENCY - NATIONS ENERGY
In September 2001, Nations Energy sold its 26% equity interest in a power
project located in Curacao, Netherlands Antilles to Mirant Curacao Investments,
Ltd. (Mirant Curacao) a subsidiary of Mirant Corporation (Mirant). Nations
Energy received $5 million in cash and an $11 million note receivable from
Mirant Curacao. The note was recorded at its net present value of $8 million
using an 8% discount rate, the discount being recognized as interest income over
the five-year life of the note. As of December 31, 2004, Nations Energy's
receivable from Mirant Curacao is approximately $8 million. The note is
primarily included in Investments and Other Property - Other on UniSource
Energy's balance sheet. The first payment of $2 million on the receivable was
received in June 2004. The remaining payments on the note receivable are
expected to be received as follows: $4 million in July 2005 and $5 million in
July 2006.
The note is guaranteed by Mirant Americas, Inc., a subsidiary of Mirant. On
July 14, 2003, Mirant, Mirant Americas, Inc. and various other Mirant companies
filed for Chapter 11 bankruptcy protection. Mirant Curacao was not included in
the Chapter 11 filings. Based on a review of the projected cash flows for the
power project, it appears Mirant Curacao will have sufficient future cash flows
to pay the note receivable and any applicable interest. However, we cannot
predict the ultimate outcome that Mirant's bankruptcy will have on the
collectibility of the note from Mirant Curacao. Nations Energy will continue to
evaluate the collectibility of the receivable, but currently expects to collect
the note in its entirety and has not recorded any reserve for this note.
GUARANTEES AND INDEMNITIES
In the normal course of business, UniSource Energy and certain subsidiaries
enter into various agreements providing financial or performance assurance to
third parties on behalf of certain subsidiaries. We enter into these agreements
primarily to support or enhance the creditworthiness of a subsidiary on a
stand-alone basis. The most significant of these guarantees are:
o UES' guarantee of $160 million of aggregate principal amount of senior
unsecured notes issued by UNS Gas and UNS Electric to purchase the
Citizens Arizona gas and electric utility assets,
o UniSource Energy's guarantee of approximately $8 million in natural
gas transportation and supply payments in addition to building and
equipment lease payments for UNS Gas, UNS Electric, and subsidiaries
of Millennium, and
o Millennium's guarantee of approximately $3 million in
commodity-related payments for MEG and building lease payments for a
subsidiary at December 31, 2004.
To the extent liabilities exist under the contracts subject to these guarantees,
such liabilities are included in UniSource Energy's consolidated balance sheets.
In addition, UniSource Energy and its subsidiaries have indemnified the
purchasers of interests in certain investments from additional taxes due for
years prior to the sale of such investments. The terms of the indemnifications
provide for no limitation on potential future payments; however, we believe that
we have abided by all tax laws and paid all tax obligations. We have not made
any payments under the terms of these indemnifications to date.
K-120
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
We believe that the likelihood UniSource Energy, UES, or Millennium would
be required to perform or otherwise incur any significant losses associated with
any of these guarantees or indemnities is remote.
NOTE 9. UTILITY PLANT AND JOINTLY-OWNED FACILITIES
---------------------------------------------------
UTILITY PLANT
The following table shows Utility Plant in Service by company and major
class at December 31:
2004 2003
-------------------------------------------------------------------------------------------------------------------------
- Millions of Dollars -
UniSource UniSource
Energy Energy
TEP UES Consolidated TEP UES Consolidated
-----------------------------------------------------------------------------------
Plant in Service:
Electric Generation Plant $1,206 $ 5 $1,211 $1,187 $ 5 $1,192
Electric Transmission Plant 539 13 552 531 11 542
Electric Distribution Plant 823 74 897 780 61 841
Gas Distribution Plant - 135 135 - 120 120
Gas Transmission Plant - 12 12 - 9 9
General Plant 146 14 160 133 10 143
Intangible Plant 56 7 63 49 2 51
Electric Plant Held for Future
Use 2 1 3 1 - 1
-------------------------------------------------------------------------------------------------------------------------
Total Plant in Service $2,772 $ 261 $3,033 $2,681 $ 218 $2,899
=========================================================================================================================
Utility Plant under Capital
Leases $ 723 $ 1 $ 724 $ 747 $ 1 $ 748
=========================================================================================================================
Intangible Plant primarily represents computer software costs. TEP's
unamortized computer software costs were $24 million as of December 31, 2004 and
December 31, 2003. UES' unamortized computer software costs were $2 million as
of December 31, 2004 and December 31, 2003.
All TEP Utility Plant under Capital Leases is used in TEP's generation
operations.
The depreciable lives currently used by TEP are as follows:
MAJOR CLASS OF UTILITY PLANT IN SERVICE DEPRECIABLE LIVES
------------------------------------------------------------------------
Electric Generation Plant 23-70 years
Electric Transmission Plant 10-50 years
Electric Distribution Plant 24-60 years
General Plant 5-45 years
Intangible Plant 3-10 years
------------------------------------------------------------------------
During the first quarter of 2004, TEP engaged an independent third party to
review the economic estimated useful lives of its owned generating assets in
Springerville, Arizona. TEP then hired a different independent third party to
perform a depreciation study for its generation assets, taking into
consideration the newly determined economic useful life for the Springerville
assets, and changes in generation plant life information used by the operators
and other participants of the joint power plants in which TEP participates. As a
result of these analyses, in July 2004, TEP lengthened the useful lives of
various generation assets for periods ranging from 11 to 22 years. Consequently,
depreciation rates and the corresponding depreciation expense have been revised
to reflect the life extensions. The annual impact of these changes in
depreciation rates is a reduction in depreciation expense of $9 million. A study
is currently underway by the operating agent of the San Juan Generating Station
K-121
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
to determine whether San Juan's economic useful life has changed from previous
estimates. If the economic life of San Juan is extended by ten years, TEP's
annual depreciation expense would decrease by an additional $4 million.
In the fourth quarter of 2004, TEP determined that one of its capital lease
assets and the corresponding obligation were overstated. To reduce the asset, a
net adjustment of $18 million was recorded and a $20 million reduction to the
obligation was recorded. In addition, a $2 million pre-tax net cumulative
reduction of previously overstated depreciation and interest expense was
recored. See Note 10 and 21.
See TEP Utility Plant in Note 1 and TEP Capital Lease Obligations in Note
10.
The depreciable lives currently used by UES are as follows:
MAJOR CLASS OF UTILITY PLANT IN SERVICE DEPRECIABLE LIVES
------------------------------------------------------------------------
Electric Generation Plant 23-40 years
Electric Transmission Plant 11-45 years
Electric Distribution Plant 14-26 years
Gas Distribution Plant 17-48 years
Gas Transmission Plant 37-55 years
General Plant 3-33 years
------------------------------------------------------------------------
JOINTLY-OWNED FACILITIES
At December 31, 2004, TEP's interests in generating stations and
transmission systems that are jointly-owned with other utilities were as
follows:
Percent Plant Construction
Owned by in Work in Accumulated
TEP Service* Progress Depreciation
--------------------------------------------------------------------------------
-Millions of Dollars-
San Juan Units 1 and 2 50.0% $302 $ 1 $211
Navajo Station Units 1,
2 and 3 7.5 128 3 69
Four Corners Units 4 and 5 7.0 80 3 65
Transmission Facilities 7.5 to 95.0 226 - 148
Luna Energy Facility 33.3 - 13 -
--------------------------------------------------------------------------------
Total $736 $20 $493
================================================================================
*Included in Utility Plant shown above.
TEP has financed or provided funds for the above facilities and TEP's share
of their operating expenses is reflected in the income statements. See Note 8
for commitments related to TEP's jointly-owned facilities.
On November 12, 2004, TEP, Phelps Dodge Energy Services, LLC and PNM
Resources, Inc. (PNMR) each purchased from Duke Energy North America, LLC a
one-third interest in a limited liability company which owned the partially
constructed natural gas-fired Luna Energy Facility (Luna). In February 2005,
most of the assets of the limited liability company were transferred to the new
owners so that each owner directly owns a one-third interest in the plant.
Luna is designed as a 570-MW combined cycle plant in southern New Mexico and is
expected to be operational by the summer of 2006. Luna is expected to provide
TEP with 190 MW of power to serve its wholesale and retail customers. PNM, an
affiliate of PNMR, will oversee the completion of construction of Luna, which is
approximately 50 percent complete, and will operate Luna.
TEP paid $13 million for its one-third interest in Luna. TEP expects to
spend up to an additional $33 million for its one-third share of the costs to
complete construction of Luna and purchase necessary inventory items, of which
$30 million will be spent in 2005 and the remainder in 2006. In addition, TEP
expects to spend $3 million for its share of the capital expenditures related to
an anticipated outage in 2009. TEP anticipates that internal cash flows will
fund its share of the costs related to the plant.
K-122
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
NOTE 10. DEBT AND CAPITAL LEASE OBLIGATIONS
--------------------------------------------
Long-term debt matures more than one year from the date of the financial
statements. UniSource Energy and TEP's long-term debt is summarized in the
statements of capitalization.
UNISOURCE ENERGY DEBT
INTERCOMPANY NOTE PAYABLE
On January 1, 1998, TEP and UniSource Energy exchanged all the outstanding
common stock of TEP on a share-for-share basis for the Common Stock of UniSource
Energy. Following the share exchange, TEP transferred the stock of Millennium to
UniSource Energy for a $95 million promissory note due in 2008. Approximately
$25 million of this note represented a gain to TEP. TEP did not record this gain
in income. Instead, this gain was reflected as an increase in TEP's common stock
equity when UniSource Energy repaid the note on March 1, 2005 (see Subsequent
Events below). In accordance with the ACC order authorizing the formation of the
holding company, interest was payable on the note every two years beginning
January 1, 2000 at a rate of 9.78% per year.
BRIDGE LOAN
In August 2003, UniSource Energy borrowed $35 million from a financial
institution in the form of short-term debt to help finance the purchase of
Citizens Arizona electric and gas utility assets. The funds were recorded as an
equity contribution in the capitalization of UNS Gas and UNS Electric. In
October 2003, as required by the debt agreement, UniSource Energy repaid the $35
million loan upon the financial close of the Springerville Unit 3 project. See
Note 14.
TEP DEBT
LONG-TERM DEBT
TEP made the required sinking fund payments of $2 million on its First
Mortgage IDBs in each of 2004 and 2003. TEP redeemed $0.4 million of its 8.5%
First Mortgage Bonds in 2003 and the remaining $27 million in 2004. TEP paid a
premium of $0.4 million related to the 2004 redemption. A portion of this
premium was expensed immediately, while the remainder is being amortized over
the original life of the bonds. TEP did not issue any new bonds in 2004 or 2003.
FIRST AND SECOND MORTGAGE INDENTURES
TEP's first and second mortgage indentures create liens on and security
interests in most of TEP's utility plant assets, with the exception of
Springerville Unit 2. San Carlos Resources Inc., a wholly-owned subsidiary of
TEP, holds title to Springerville Unit 2. Utility Plant under Capital Leases is
not subject to such liens or available to TEP creditors, other than the lessors.
The net book value of TEP's utility plant subject to the lien of the indentures
was $1,166 million at December 31, 2004.
BANK CREDIT AGREEMENT
On March 25, 2004, TEP entered into a new $401 million credit agreement.
The agreement replaces the credit facilities provided under TEP's $401 million
credit agreement that would have expired in 2006. The new credit agreement
includes a $60 million revolving credit facility for general corporate purposes
and a $341 million letter of credit facility, to support $329 million aggregate
principal amount of tax-exempt variable rate bonds. The credit agreement has a
five year term through June 30, 2009 and is secured by $401 million in aggregate
principal amount of Second Mortgage Bonds issued under TEP's General Second
Mortgage Indenture.
The credit agreement contains a number of restrictive covenants, including
restrictions on additional indebtedness, liens, sale of assets and
sale-leasebacks. The credit agreement also contains several financial covenants
including: (a) minimum consolidated tangible net worth, (b) a minimum cash
coverage ratio, and (c) a maximum leverage ratio. Under the terms of the credit
agreement, TEP may pay dividends so long as it maintains compliance with the
credit agreement. The credit agreement also provides that under certain
K-123
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
circumstances, certain regulatory actions could result in a required reduction
of the commitments. As of December 31, 2004, TEP was in compliance with the
terms of the credit agreement.
The letter of credit fee of 2.35% on the new facility is significantly
lower than the previous credit agreement's weighted average letter of credit fee
of approximately 5%. The agreement also provides for letter of credit fronting
fees of 0.25%, the same rate as the previous agreement. Unreimbursed drawings on
a letter of credit bear a variable rate of interest based on LIBOR plus 2.25%
per annum. Interest savings in 2004 were partially offset by the March 2004
write-off of $2 million of fees associated with the prior facility that were
capitalized and being amortized through 2006. These fees were related to debt
associated with the generation portion of TEP's operations. Fees of $9 million
associated with the entry into the new facility are being amortized through June
2009. This expense is included in Long-Term Debt Interest Expense in UniSource
Energy and TEP's income statements.
At December 31, 2004, TEP had no outstanding borrowings under the revolving
credit facility. If TEP borrows under the revolving credit facility, the
borrowing costs would be at a variable interest rate consisting of a spread over
LIBOR or an alternate base rate. The spread is based upon a pricing grid tied to
TEP's leverage. The per annum rate currently in effect on borrowings under TEP's
revolving credit facility, based on its leverage, is LIBOR plus 2.25%. If TEP's
leverage were to change, the spread over LIBOR could range from 1.50% to 2.25%.
TEP also pays a commitment fee of 0.50% on the unused portion of the revolving
credit facility.
TEP CAPITAL LEASE OBLIGATIONS
The terms of TEP's capital leases are as follows:
o The Sundt Lease has an initial term to January 2011 and provides for
renewal periods of two or more years through 2020.
o The Springerville Common Facilities Leases have an initial term to
December 2017 for one lease and January 2021 for the other two leases,
subject to optional renewal periods of two or more years through 2025.
o The Springerville Unit 1 Leases have an initial term to January 2015
and provide for renewal periods of three or more years through 2030.
o The Springerville Coal Handling Facilities Leases have an initial term
to April 2015 and provide for one renewal period of six years, then
additional renewal periods of five or more years through 2035.
On or before each lease expiration date, TEP will determine if it will
purchase the assets at the value stipulated in the lease or renegotiate the
lease term. In some of the leases, the stipulated value is a fixed amount, and
in others it is at fair market value.
SPRINGERVILLE LEASE DEBT AND EQUITY
TEP held an investment in Springerville Unit 1 lease debt totaling $98
million at December 31, 2004 and $100 million at December 31, 2003. TEP
purchased an additional $4 million of Springerville Unit 1 lease debt in 2004,
but made no comparable purchases in 2003. TEP received $7 million in principal
payments related to this investment in each of 2004 and 2003.
In the fourth quarter of 2004, TEP determined that one of its capital lease
assets and the corresponding obligation were overstated. To reduce the
obligation, an adjustment of $20 million was recorded. See Note 9 and 21.
TEP also held an investment in Springerville Coal Handling Facilities lease
debt totaling $73 million at December 31, 2004 and $79 million at December 31,
2003. TEP received $5 million in principal payments related to this investment
in each of 2004 and 2003. TEP purchased a 13% ownership interest in the
Springerville Coal Handling Facilities Leases for $13 million in December 2001
and all $96 million of the debt related to these capital leases in January 2002.
In March 2002, TEP terminated the lease related to its equity interest and
cancelled the associated debt. As a result of the lease termination, TEP
recorded a $21 million reduction to the capital lease obligation, a $27 million
reduction of its investment, and a $6 million increase in the capital lease
asset, which represented the residual value of TEP's interest in the leased
asset.
TEP recognizes interest income on these investments. TEP's purchases of
lease debt and equity are reflected in investing activities on TEP's cash flow
statements.
K-124
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
In 1985, TEP sold and leased back its undivided one-half ownership interest
in the common facilities at the Springerville Generating Station. Under the
terms of the Springerville Common Facilities Leases, TEP must periodically
arrange for refinancing or refunding of the secured notes underlying the leases
prior to the named date in order to avoid a special event of loss. The special
event of loss date is currently set at June 30, 2006. Interest on the debt is
payable at LIBOR plus 4.25%. The LIBOR rate is reset every six months and the
average rate in effect on December 31, 2004 was 1.92%, which resulted in a total
average interest rate on the lease debt of 6.17% at year end.
UNS GAS AND UNS ELECTRIC LONG-TERM DEBT
SENIOR UNSECURED NOTES
On August 11, 2003, UNS Gas and UNS Electric issued a total of $160 million
of aggregate principal amount of senior unsecured notes in a private placement.
Proceeds from the note issuance were paid to Citizens to purchase the Arizona
gas and electric system assets. UNS Gas issued $50 million of 6.23% notes due
August 11, 2011 and $50 million of 6.23% notes due August 11, 2015. UNS Electric
issued $60 million of 7.61% notes due August 11, 2008. All three series of notes
may be prepaid with a make-whole call premium reflecting a discount rate equal
to an equivalent maturity U.S. Treasury security yield plus 50 basis points. UNS
Gas and UNS Electric incurred a total of $2 million in debt costs related to the
issuance of the notes. These costs were deferred and are being amortized over
the life of the notes. The notes are guaranteed by UES.
The note purchase agreements for both UNS Gas and UNS Electric contain
certain restrictive covenants, including restrictions on transactions with
affiliates, mergers, liens to secure indebtedness, restricted payments,
incurrence of indebtedness, and minimum net worth. For purposes of these notes,
net worth equals common stock equity less amounts attributable to minority
interests and intangible assets not recoverable through rates. The actual and
required minimum net worth levels at December 31, 2004 were as follows:
Required
Minimum Net Actual
Net Worth Net Worth
---------------------------------------------
-Millions of Dollars-
UES $ 50 $ 100
UNS Gas 43 59
UNS Electric 26 41
---------------------------------------------
The incurrence of indebtedness covenant requires each of UNS Gas and UNS
Electric to meet certain tests before an additional dollar of indebtedness may
be incurred. These tests include (a) a ratio of Consolidated Long-Term Debt to
Consolidated Total Capitalization of no greater than 0.65 to 1.00, and (b) an
Interest Coverage Ratio (a measure of cash flow to cover interest expense) of at
least 2.50 to 1.00. However, UNS Gas and UNS Electric may, without meeting these
tests, refinance indebtedness and incur short-term debt in an amount not to
exceed $7 million in the case of UNS Gas, and $5 million in the case of UNS
Electric. Neither UNS Gas nor UNS Electric, may declare or make distributions or
dividends (restricted payments) on their common stock unless (a) immediately
after giving effect to such action no default or event of default would exist
under such company's note purchase agreement and (b) immediately after giving
effect to such action, such company would be permitted to incur an additional
dollar of indebtedness under the debt incurrence test for such company. As of
December 31, 2004, UNS Gas and UNS Electric were in compliance with the terms of
the note purchase agreements.
MEG LINE OF CREDIT
MEG has a bank line of credit for the purpose of issuing letters of credit
to counterparties to support its emissions allowance and coal trading
activities. In September 2004, MEG reduced this bank line of credit from $5
million to $3 million. As of December 31, 2004, MEG had $2 million in
outstanding LOCs, all of which had expired by the end of February 2005. In
accordance with UniSource Energy's intention to cease making capital
contributions to Millennium, Millennium has significantly reduced the holdings
and activity of MEG. MEG is in the process of winding down its activities and
will not engage in any new activities after 2005. MEG's bank line of credit
will expire on March 27, 2005 and will not be renewed.
K-125
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
MATURITIES AND SINKING FUND REQUIREMENTS
Long-term debt, including sinking funds, and capital lease obligations
mature on the following dates:
Scheduled
IDBs Long-Term Capital UniSource
Supported Debt Lease TEP UNS UNS Energy
by LOCs Retirements (1) Obligations Total Gas Electric Total
------------- ------------------- --------------- ----------- ----------- ------------ -------------
-Millions of Dollars-
2005 $ - $ 2 $ 120 $ 122 $ - $ - $ 122
2006 - 21 123 144 - - 144
2007 - 1 128 129 - - 129
2008 - 167 121 288 - 60 348
2009 329 - 68 397 - - 397
--------------------------------------------------------------------------------------------------------------------------------
Total 2005-2009 329 191 560 1,080 - 60 1,140
Thereafter - 579 780 1,359 100 - 1,459
Less: Imputed Interest - - (585) (585) - - (585)
--------------------------------------------------------------------------------------------------------------------------------
Total $ 329 $ 770 $ 755 $ 1,854 $ 100 $ 60 $ 2,014
================================================================================================================================
(1) As discussed above, TEP redeemed its remaining First Mortgage IDBs in
March 2005. If this redemption were reflected in this table, the only
remaining Scheduled Long-Term Debt Retirement for 2005-2009 would be $138
million in 2008.
SUBSEQUENT EVENTS
On March 1, 2005, UniSource Energy issued $150 million aggregate principal
amount of 4.50% Convertible Senior Notes due 2035 through a domestic offering to
qualified institutional buyers pursuant to Rule 144A under the Securities Act of
1933 (the Act) and to persons in offshore transactions in reliance on Regulation
S under the Act. Each $1,000 principal amount of notes is convertible into
26.6667 shares of UniSource Energy Common Stock at any time, representing a
conversion price of approximately $37.50 per share of UniSource Energy Common
Stock, subject to adjustment in certain circumstances. Beginning on March 5,
2010, UniSource Energy will have the option to redeem the notes, in whole or in
part, for cash, at a price equal to 100% of the principal amount plus accrued
and unpaid interest. Holders of the notes will have the ability to require
UniSource Energy to repurchase the notes, in whole or in part, for cash on March
1, 2015, 2020, 2025 and 2030, or if certain specified fundamental changes
involving UniSource Energy occur. The repurchase price will be 100% of the
principal amount of the notes plus accrued and unpaid interest.
On March 1, 2005, UniSource Energy used $106 million of the net proceeds
from this offering to repay the $95 million promissory note to TEP plus accrued
interest of $11 million. UniSource Energy expects that TEP will use these funds
to redeem or repurchase certain of TEP's existing indebtedness through
transactions that may include negotiated or market purchases, tender offers and
redemptions. TEP has not yet determined the series of debt to be redeemed or
repurchased.
TEP made the required sinking fund payment of $1 million on its 6.1% First
Mortgage IDBs in January 2005. In March 2005, TEP redeemed at par the remaining
$31 million of its 6.1% First Mortgage IDBs, which were due in 2008, as well as
the remaining $21 million of its 7.5% First Mortgage IDBs, which were due in
2006.
NOTE 11. FAIR VALUE OF FINANCIAL INSTRUMENTS
---------------------------------------------
The carrying values and fair values of our financial instruments are as
follows:
K-126
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
December 31,
2004 2003
---------------------------------------------------
Carrying Fair Carrying Fair
Value Value Value Value
---------------------------------------------------
-Millions of Dollars-
ASSETS:
TEP Springerville Lease Debt Securities (included in
Investments and Other Property) $ 171 $ 182 $ 179 $ 198
LIABILITIES:
TEP First Mortgage Bonds - Fixed Rate:
Corporate - - 27 27
IDBs 53 53 55 55
First Collateral Trust Bonds 138 153 138 155
TEP Second Mortgage Bonds - IDBs (Variable Rate) 329 329 329 329
TEP Unsecured IDBs - Fixed Rate 579 568 579 582
UNS Gas Senior Unsecured Notes 100 108 100 100
UNS Electric Senior Unsecured Notes 60 64 60 60
---------------------------------------------------
See Note 10 for a description of TEP's investment in Springerville Lease
Debt. TEP intends to hold the $171 million investment in Springerville Lease
Debt Securities to maturity ($39 million matures through January 1, 2009, $73
million matures through July 1, 2011, and $59 million matures through January 1,
2013). This investment is stated at amortized cost, which means the purchase
cost has been adjusted for the amortization of the premium and discount to
maturity. TEP determined the fair value of this investment by calculating the
present value of the cash flows of each note, using a discount rate consistent
with market yields generally available as of December 31, 2004 and December 31,
2003 for bonds with similar characteristics with respect to credit rating and
time-to-maturity. The use of different market assumptions and/or estimation
methodologies may yield different estimated fair value amounts.
TEP considers the principal amounts of variable rate debt outstanding to be
reasonable estimates of their fair value. TEP determined the fair value of its
taxable fixed rate obligations including the Corporate First Mortgage Bonds and
First Collateral Trust Bonds by calculating the present value of the cash flows
of each fixed rate obligation. TEP used a rate consistent with market yields
generally available as of December 31, 2004 and December 31, 2003 for bonds with
similar characteristics with respect to credit rating and time-to-maturity. The
use of different market assumptions and/or estimation methodologies may yield
different estimated fair value amounts. TEP based the fair value of its
tax-exempt fixed rate obligations including the First Mortgage IDBs and the
Unsecured IDBs on quoted market prices for the same or similar debt.
As of December 31, 2004, UNS Gas and UNS Electric determined the fair value
of the $160 million of senior unsecured notes by calculating the present value
of the cash flows of each note, using a discount rate consistent with market
yields generally available as of December 31, 2004 for bonds with similar
characteristics with respect to credit rating and time-to-maturity. The use of
different market assumptions and/or estimation methodologies may yield different
estimated fair value amounts. As of December 31, 2003, UNS Gas and UNS Electric
considered the principal amounts of these notes, which were issued in August
2003, to be reasonable estimates of their fair value.
The carrying amounts of our current assets and liabilities approximate fair
value.
NOTE 12. STOCKHOLDERS' EQUITY
------------------------------
DIVIDEND LIMITATIONS
UNISOURCE ENERGY
In February 2005, UniSource Energy declared a quarterly dividend to the
shareholders of $0.19 per share of UniSource Energy Common Stock. The dividend,
totaling approximately $7 million, was paid on March 8, 2005 to common
shareholders of record as of February 15, 2005. In 2004, UniSource Energy paid
quarterly dividends to the shareholders of $0.16 per share, for a total of $0.64
per share, or $22 million, for the year. During 2003, UniSource Energy paid
quarterly dividends to the shareholders of $0.15 per share, for a total of $0.60
K-127
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
per share, or $20 million, for the year. During 2002, UniSource Energy paid
quarterly dividends to the shareholders of $0.125 per share, for a total of
$0.50 per share, or $17 million, for the year.
Our ability to pay cash dividends on Common Stock outstanding depends, in
part, upon cash flows from our subsidiaries: TEP, UES, Millennium and UED.
Additionally, as a result of the acquisition agreement discussed in Note 2,
UniSource Energy's quarterly dividend payment was limited to no more than $0.16
per share in 2004.
TEP
TEP paid dividends of $32 million in 2004, $80 million in 2003, and $35
million in 2002. UniSource Energy is the primary holder of TEP's common stock.
TEP met the following requirements before paying these dividends:
o BANK CREDIT AGREEMENT
TEP's new Credit Agreement as of March 2004 allows TEP to pay dividends as
long as TEP maintains compliance with the agreement and certain financial
covenants.
o ACC HOLDING COMPANY ORDER
The ACC Holding Company Order does not allow TEP to pay dividends in
excess of 75% of its annual earnings until TEP's equity ratio equals 37.5% of
total capitalization, excluding capital lease obligations. The UES Settlement
Agreement, as approved by the ACC, modifies this dividend limitation so that it
will remain in place until TEP's common equity equals 40% of total
capitalization (excluding capital lease obligations).
o FEDERAL POWER ACT
This Act states that dividends shall not be paid out of funds properly
included in capital accounts. TEP's 2004, 2003 and 2002 dividends were paid from
current year earnings.
UES
UES did not pay any dividends to UniSource Energy in 2004 or 2003. UES'
ability to pay dividends is limited by restrictions placed on its subsidiaries,
UNS Gas and UNS Electric. As discussed in Note 3, the UES Settlement Agreement
limits dividends payable by both UNS Gas and UNS Electric to UniSource Energy to
75% of earnings until the ratio of common equity to total capitalization reaches
40%. UNS Electric met this ratio requirement at December 31, 2004. Additionally,
the terms of the senior unsecured note agreements entered into by both UNS Gas
and UNS Electric contain dividend restrictions. See Note 10.
MILLENNIUM AND UED
Millennium did not pay any dividends to UniSource Energy in 2004, 2003 or
2002. UED did not pay any dividends to UniSource Energy in 2004 or 2002. UED
paid a dividend to UniSource Energy of $50 million in 2003. Millennium and UED
have no dividend restrictions.
UNISOURCE ENERGY SHAREHOLDER RIGHTS PLAN
In March 1999, UniSource Energy adopted a Shareholder Rights Plan. As of
April 1, 1999, each Common Stock shareholder receives one Right for each share
held. Each Right initially allows shareholders to purchase UniSource Energy's
Series X Preferred Stock at a specified purchase price. However, the Rights are
exercisable only if a person or group (the "acquirer") acquires or commences a
tender offer to acquire 15% or more of UniSource Energy Common Stock. Each Right
would entitle the holder (except the acquirer) to purchase a number of shares of
UniSource Energy Common or Preferred Stock (or, in the case of a merger of
UniSource Energy into another person or group, common stock of the acquiring
person) having a fair market value equal to twice the specified purchase price.
At any time until any person or group has acquired 15% or more of the Common
Stock, UniSource Energy may redeem the Rights at a redemption price of $0.001
per Right. The Rights trade automatically with the Common Stock when it is
bought and sold. The Rights expire on March 31, 2009.
K-128
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
NOTE 13. TEP WHOLESALE ACCOUNTS RECEIVABLE AND ALLOWANCES
----------------------------------------------------------
TEP's Accounts Receivable from Electric Wholesale Sales, included in Trade
Accounts Receivable on the balance sheet, totaled $22 million at December 31,
2004 and $26 million at December 31, 2003, net of allowances. TEP's Allowance
for Doubtful Accounts on the balance sheet includes $13 million at December 31,
2004 and $10 million at December 31, 2003 related to sales to the California
Power Exchange (CPX) and the California Independent System Operator (CISO) in
2001 and 2000. Excluding the receivables from the CPX and the CISO,
substantially all of the December 31, 2004 wholesale receivable balance has been
collected as of the date of this filing.
TEP's collection shortfall from the CPX and the CISO was approximately $9
million for sales made in 2000 and $7 million for sales made in 2001. Since that
time, the FERC staff has proposed various methodologies for calculating amounts
of refunds/offsets applicable to wholesale sales made into the CISO's spot
markets from October 2000 to June 2001. Based upon a FERC order in March 2003
(as reaffirmed by the FERC on October 16, 2003), TEP estimated that it would
receive approximately $6 million of its $16 million receivable. In May 2004, the
FERC issued two separate orders addressing numerous issues in the refund
calculation and the fuel cost allowance calculation (an offset to the refund
obligation). Based on these new orders, TEP increased its reserve for sales to
the CPX and the CISO by $3 million by recording a reduction of wholesale
revenues.
There are several other outstanding legal issues, complaints and lawsuits
concerning the California energy crisis related to the FERC, wholesale power
suppliers, Southern California Edison Company, Pacific Gas and Electric Company,
the CPX and the CISO. We cannot predict the outcome of these issues or lawsuits.
We believe, however, that TEP is adequately reserved for its transactions with
the CPX and the CISO.
NOTE 14. SPRINGERVILLE EXPANSION
---------------------------------
On October 21, 2003 (the Closing Date), UED, TEP, Tri-State Generation and
Transmission Association, Inc. (Tri-State) and Salt River Project Agricultural
Improvement and Power District (SRP) entered into an Amended and Restated Joint
Development Agreement, which provides for the development of two 400 MW
coal-fired units at TEP's existing Springerville Generating Station by parties
other than TEP.
On the Closing Date, TEP transferred the right to construct Unit 3,
together with associated rights, to Tri-State. Tri-State completed financing of
Unit 3 on that date and immediately began construction. Once the unit is
completed, Tri-State will lease 100% of Unit 3 through a 34-year leveraged lease
agreement with GE Structured Finance and will take 300 MW of the 400 MW
capacity.
Under the Joint Development Agreement, SRP will purchase 100 MW of Unit
3's capacity from Tri-State under a 30-year power purchase agreement and will
have the right to construct and own Unit 4 at a later date. If SRP decides to
construct Unit 4, TEP and Tri-State may be required to find a replacement
purchaser for SRP's 100 MW power purchase obligation from Unit 3. If TEP and
Tri-State are unable to find a replacement purchaser, TEP would then purchase
100 MW of output from Unit 4, beginning with its commercial operation.
TEP executed contracts to provide operating, maintenance and other
services to Units 3 and 4. TEP also agreed to purchase up to 100 MW of Tri-State
system capacity for no more than five years from the time Unit 3 begins
commercial operation, which we expect to occur in December 2006. TEP will
benefit from approximately $90 million in upgraded emissions control equipment
for Units 1 and 2 and other facilities at the Springerville Generating Station
that will be paid for by the Unit 3 project. Due to the transfer of Unit 3
rights to Tri-State, in November 2003 TEP deposited $17 million with TEP's
Second Mortgage Trustee in compliance with TEP's Credit Agreement. Such deposit
was returned to TEP in 2004 when TEP refinanced its Credit Agreement and
eliminated this requirement.
On the Closing Date, UED received reimbursement of all project development
costs which it incurred in connection with Units 3 and 4 of approximately $29
million, plus a development fee (including accrued interest on development funds
advanced) of $11 million. We recognized the development fee as income in the
fourth quarter of 2003. On October 24, 2003, UniSource Energy repaid its $35
million short-term bridge loan with the proceeds.
K-129
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
NOTE 15. INCOME AND OTHER TAXES
--------------------------------
INCOME TAXES
We record deferred tax liabilities for amounts that will increase income
taxes on future tax returns. We record deferred tax assets for amounts that
could be used to reduce income taxes on future tax returns. We record a Deferred
Tax Assets Valuation Allowance for the amount of Deferred Tax Assets that we may
not be able to use on future tax returns. We estimate the valuation allowance
based on our interpretation of the tax rules, prior tax audits, tax planning
strategies, scheduled reversal of deferred tax liabilities, and projected future
taxable income.
Deferred tax assets (liabilities) consist of the following:
UNISOURCE ENERGY TEP
----------------------------------------------------------------
December 31, December 31,
2004 2003 2004 2003
------------------------------------------------------------------------------------------------------------------------
-Millions of Dollars-
GROSS DEFERRED INCOME TAX LIABILITIES
Plant - Net $ (478) $ (476) $ (470) $ (474)
Income Taxes Recoverable Through Future
Revenues Regulatory Asset (20) (22) (20) (22)
Transition Recovery Asset (89) (108) (89) (108)
Other (33) (31) (27) (27)
------------------------------------------------------------------------------------------------------------------------
GROSS DEFERRED INCOME TAX LIABILITY (620) (637) (606) (631)
------------------------------------------------------------------------------------------------------------------------
GROSS DEFERRED INCOME TAX ASSETS
Capital Lease Obligations 314 337 314 337
Net Operating Loss Carryforwards (NOL) 7 18 - 11
Investment Tax Credit Carryforwards 5 8 5 8
Alternative Minimum Tax Credit (AMT) 100 88 92 85
Accrued Postretirement Benefits 19 17 19 17
Emission Allowance Inventory 14 14 14 14
Coal Contract Termination Fees 14 16 14 16
Springerville Coal Handling Facility 6 7 6 7
Reserve for Uncollectible Accounts 6 4 6 4
Unregulated Investment Losses 30 30 1 1
Minimum Pension Liability 7 1 7 1
Vacation & Sick Accrual 3 3 3 3
Other 25 21 20 18
------------------------------------------------------------------------------------------------------------------------
GROSS DEFERRED INCOME TAX ASSET 550 564 501 522
DEFERRED TAX ASSETS VALUATION ALLOWANCE (8) (7) (1) -
------------------------------------------------------------------------------------------------------------------------
NET DEFERRED INCOME TAX LIABILITY $ (78) $ (80) $ (106) $ (109)
========================================================================================================================
The net deferred income tax liability is included in the balance sheets in
the following accounts:
UNISOURCE ENERGY TEP
--------------------------------------------------------------
December 31, December 31,
2004 2003 2004 2003
------------------------------------------------------------------------------------------------------------------------
-Millions of Dollars-
Deferred Income Taxes - Current Assets $ 24 $ 16 $ 24 $ 19
Deferred Income Taxes - Noncurrent Liabilities (102) (96) (130) (128)
------------------------------------------------------------------------------------------------------------------------
NET DEFERRED INCOME TAX LIABILITY $ (78) $ (80) $ (106) $ (109)
========================================================================================================================
The valuation allowance of $8 million at December 31, 2004 and $7 million
at December 31, 2003, which reduces the Deferred Tax Asset balance, relates to
Net Operating Loss (NOL) and Investment Tax Credit (ITC) carryforward amounts.
K-130
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
The increase of $1 million is related to TEP's ITC carryforward. Of the $8
million valuation allowance at December 31, 2004, $7 million relates to losses
generated by the Millennium entities. In the future, if UniSource Energy and the
Millennium entities determine that all or a portion of the losses may be used on
tax returns, then UniSource Energy and the Millennium entities would reduce the
valuation allowance and recognize benefit of up to $7 million. The primary
factor that could cause the Millennium entities to recognize a tax benefit would
be a change in expected future taxable income. The remaining $1 million
valuation allowance at December 31, 2004 relates to ITC carryfowards at TEP
which may not be utilized on tax returns prior to their expiration. If in the
future UniSource Energy and TEP determine that it is probable that TEP will not
use all or a portion of additional ITC carryforward amounts, then UniSource
Energy and TEP would record additional valuation allowance and recognize tax
expense. The primary factor that could cause TEP to record additional valuation
allowance would be a change in expected future taxable income.
In 2003, the Deferred Tax Assets Valuation Allowance decreased $15 million
due primarily to TEP's expectation of using a portion of its NOL and ITC
carryforward amounts. This resulted in the reduction of Income Tax Expense for
the year ended December 31, 2003.
In 2002, the Deferred Tax Assets Valuation Allowance decreased $1 million
due primarily to the settlement of audits.
As of December 31, 2004 UniSource Energy's deferred income tax assets
include $14 million related to unregulated investment losses of Millennium.
TEP's deferred income tax assets include $1 million related to unregulated
investment losses. These losses have not been reflected on UniSource Energy
consolidated income tax returns. If UniSource Energy is unable to recognize such
losses through its consolidated income tax return in the forseeable future,
UniSource Energy and TEP would be required to write off these deferred tax
assets. Millennium intends to restructure its ownership in one of these
investments, Infinite Power Solutions (IPS), in 2005. As a result of this
restructuring, we expect to liquidate IPS for tax purposes resulting in a
taxable loss that will be reflected on UniSource Energy's consolidated income
tax return. If this liquidation, or another action resulting in the recognition
of the loss for tax purposes, does not occur UniSource Energy would be required
to eliminate the deferred tax assets and recognize additional tax expense of $6
million.
TEP had a net intercompany tax payable to affiliates of $4 million at
December 31, 2004 and $2 million at December 31, 2003. These amounts are
included in TEP's intercompany accounts on its balance sheet.
In 2004, UniSource Energy recognized $1 million of tax benefit as a result
of the settlement of a state income tax audit. This amount is included in the
income tax expense (benefit) tables below.
In 2003, UniSource Energy recognized $1 million of tax and interest
expense in anticipation of settlement of state income tax audits and settlement
of a state sales tax audit. The income taxes are included in the expense
(benefit) tables below.
In 2002, UniSource Energy recognized a tax benefit of $1.5 million as a
result of final agreement with the IRS on audit issues and a tax benefit of
$1 million from recognition of losses generated by the sale of a Nations Energy
foreign entity.
In 2004, the tax effect of the exercise of certain employee stock options
that are recognized differently for financial reporting and tax purposes was not
recorded as a timing difference, but rather was credited to shareholder's
equity. This resulted in a $1.5 million increase to the capital of UniSource
Energy.
Additionally, in 2004, as a result of the termination of the UniSource
Energy acquisition, UniSource Energy and TEP deducted certain legal and advisory
fees which had previously been treated as permanently nondeductible expense. As
a result, a current tax benefit of $1.1 million was recognized in the fourth
quarter of 2004.
K-131
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
Income tax expense (benefit) included in the income statements consists of
the following:
UNISOURCE ENERGY TEP
------------------------------ ----------------------------
Years Ended December 31,
2004 2003 2002 2004 2003 2002
--------------------------------------------------------------------------- ----------------------------
-Millions of Dollars-
Current Tax Expense
Federal $ 21 $ 11 $ 20 $ 28 $ 14 $ 23
State 7 5 7 8 7 8
--------------------------------------------------------------------------- ----------------------------
Total 28 16 27 36 21 31
--------------------------------------------------------------------------- ----------------------------
Deferred Tax Expense (Benefit)
Federal 7 12 (1) - 16 9
State (2) (1) (7) (2) (1) (3)
--------------------------------------------------------------------------- ----------------------------
Total 5 11 (8) (2) 15 6
--------------------------------------------------------------------------- ----------------------------
Increase (Reduction) in Valuation
Allowance 1 (15) (1) 1 (15) (1)
--------------------------------------------------------------------------- ----------------------------
Total Federal and State Income Tax
Expense Before Cumulative Effect
of Accounting Change 34 12 18 35 21 36
--------------------------------------------------------------------------- ----------------------------
Tax On Cumulative Effect of
Accounting Change (See Note 5) - 44 - - 44 -
--------------------------------------------------------------------------- ----------------------------
Total Federal and State Income
Tax Expense Including Cumulative
Effect of Accounting Change $ 34 $ 56 $ 18 $ 35 $ 65 $ 36
=========================================================================== ============================
The differences between the income tax expense and the amount obtained by
multiplying pre-tax income by the U.S. statutory federal income tax rate of 35%
are as follows:
UNISOURCE ENERGY TEP
---------------------------------------------------------------
Years Ended December 31,
2004 2003 2002 2004 2003 2002
----------------------------------------------------------------------------------------------------------
-Millions of Dollars-
FEDERAL INCOME TAX EXPENSE AT
STATUTORY RATE $ 28 $ 21 $ 19 $ 28 $ 29 $ 33
State Income Tax Expense,
Net of Federal Deduction 4 3 2 4 4 4
Depreciation Differences
(Flow Through Basis) 3 4 4 3 4 4
Federal/State Credits (1) (2) (4) (1) (2) (4)
Increase (Reduction) in Valuation
Allowance 1 (15) (1) 1 (15) (1)
Other (1) 1 (2) - 1 -
----------------------------------------------------------------------------------------------------------
Total Federal and State Income Tax
Expense Before Cumulative Effect
of Accounting Change $ 34 $ 12 $ 18 $ 35 $ 21 $ 36
==========================================================================================================
The Total Federal and State Income Tax Expense in the tables above is
included on UniSource Energy and TEP's income statements.
At December 31, 2004, UniSource Energy and TEP had, for federal and state
income tax filing purposes, the following carryforward amounts:
UNISOURCE ENERGY TEP
---------------------------------------- --------------------------------------
Amount Expiring Amount Expiring
---------------------------------------- --------------------------------------
-Millions of Dollars- Year -Millions of Dollars- Year
----------------------------------------------------------------------------------------------------------
Net Operating Losses $ 18 2021-2022 $ - -
Investment Tax Credit 5 2004-2024 5 2004-2024
AMT Credit 100 - 92 -
----------------------------------------------------------------------------------------------------------
K-132
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
The $18 million in NOL carryforwards at UniSource Energy is subject to
limitation due to a reorganization of certain Millennium entities in December
2002. The future utilization of these losses is dependant upon the generation of
sufficient future taxable income at the separate company level.
OTHER TAXES
TEP and UES act as conduits or collection agents for excise tax (sales
tax) as well as franchise fees and regulatory assessments. They record
liabilities payable to governmental agencies when they bill their customers for
these amounts. Neither the amounts billed nor payable are reflected in the
income statement.
NOTE 16. EMPLOYEE BENEFIT PLANS
--------------------------------
PENSION BENEFIT PLANS
TEP and UES maintain noncontributory, defined benefit pension plans for
substantially all regular employees and certain affiliate employees. Benefits
are based on years of service and the employee's average compensation. TEP and
UES fund the plans by contributing at least the minimum amount required under
Internal Revenue Service regulations. Additionally, we provide supplemental
retirement benefits to certain employees whose benefits are limited by IRS
benefit or compensation limitations.
OTHER POSTRETIREMENT BENEFIT PLANS
TEP provides limited health care and life insurance benefits for retirees.
All regular employees may become eligible for these benefits if they reach
retirement age while working for TEP or an affiliate.
TEP amended its other postretirement benefit plan to cap Medicare
supplement payments for all current retirees under age 65 and all classified
employees retiring after December 31, 2002 and eliminate post-65 medical
benefits for all salaried employees retiring after January 1, 2002. These
amendments required TEP to recalculate benefits related to participants' past
service. TEP is amortizing the change in the benefit cost from these plan
amendments on a straight-line basis over 10 years.
UniSource Energy acquired the Arizona gas and electric system assets from
Citizens on August 11, 2003, assuming a $2 million liability for postretirement
medical benefits for current retirees and a small group of active employees. The
majority of UES employees do not currently participate in the postretirement
medical plan.
The ACC allows TEP and UES to recover postretirement costs through rates
only as benefit payments are made to or on behalf of retirees. The
postretirement benefits are currently funded entirely on a pay-as-you-go basis.
Under current accounting guidance, TEP and UES cannot record a regulatory asset
for the excess of expense calculated per Statement of Financial Accounting
Standards No. 106, Employers' Accounting for Postretirement Benefits Other Than
Pensions, over actual benefit payments.
FASB Staff Position No. FAS 106-2, Accounting and Disclosure Requirements
Related to the Medicare Prescription Drug, Improvement and Modernization Act of
2003 (FSP 106-2), provides guidance related to accounting for the federal
subsidy available to certain employers providing retirees with prescription drug
benefits. For public companies, FSP 106-2 is effective for the first interim or
annual period beginning after June 15, 2004. Adoption of FSP 106-2 did not have
a significant impact on our postretirement benefit costs or cash flows because
prescription drug coverage is only available to a limited number of UniSource
Energy retirees who are Medicare eligible.
The actuarial present values of all pension benefit obligations and other
postretirement benefit plans were measured at December 1. The tables below
include both TEP and UES plans. Amounts included for UES plans are not
significant. The change in benefit obligation and plan assets and reconciliation
of the funded status are as follows:
K-133
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
OTHER POSTRETIREMENT
PENSION BENEFITS BENEFITS
------------------------------------------------------------
Years Ended December 31,
2004 2003 2004 2003
----------------------------------------------------------------------------------------------------------------------
-Millions of Dollars-
CHANGE IN BENEFIT OBLIGATION
Benefit Obligation at Beginning of Year $ 162 $ 133 $ 68 $ 59
Actuarial (Gain) Loss 16 16 (1) 3
Interest Cost 10 9 3 4
Service Cost 6 5 2 2
Benefits Paid (6) (5) (2) (2)
Plan Amendments - 4 - -
Acquisition Adjustment - - - 2
----------------------------------------------------------------------------------------------------------------------
Benefit Obligation at End of Year 188 162 70 68
----------------------------------------------------------------------------------------------------------------------
CHANGE IN PLAN ASSETS
Fair Value of Plan Assets at Beginning of Year 124 106 - -
Actual Return on Plan Assets 12 20 - -
Benefits Paid (6) (5) (2) (2)
Employer Contributions 6 3 2 2
----------------------------------------------------------------------------------------------------------------------
Fair Value of Plan Assets at End of Year 136 124 - -
----------------------------------------------------------------------------------------------------------------------
RECONCILIATION OF FUNDED STATUS TO BALANCE SHEET
Funded Status (Difference between Benefit
Obligation and Fair Value of Plan Assets) (52) (38) (70) (68)
Unrecognized Net Loss 50 37 30 33
Unrecognized Prior Service Cost (Benefit) 13 15 (10) (11)
----------------------------------------------------------------------------------------------------------------------
Net Amount Recognized in the Balance Sheets $ 11 $ 14 $ (50) $ (46)
======================================================================================================================
AMOUNTS RECOGNIZED IN THE BALANCE SHEETS
CONSIST OF:
Prepaid Pension Costs Included in Other Assets $ 17 $ 10 $ - $ -
Accrued Benefit Liability Included in Other
Liabilities (35) (9) (50) (46)
Intangible Asset Included in Other Assets 9 10 - -
Accumulated Other Comprehensive Income 20 3 - -
------------------------------------------------------------------------------------------------------------------------
Net Amount Recognized $ 11 $ 14 $ (50) $ (46)
========================================================================================================================
The accumulated benefit obligation (ABO) for all defined benefit pension
plans was $154 million and $130 million at December 31, 2004 and 2003,
respectively. The ABO was impacted by changes in actuarial assumptions including
revised retirement rates and updated mortality rates in addition to a reduction
in the discount rate.
DECEMBER 31,
2004 2003
--------------------------------------------------------------------------------
-Millions of Dollars-
INFORMATION FOR PENSION PLANS WITH AN
ACCUMULATED BENEFIT OBLIGATION IN
EXCESS OF PLAN ASSETS:
Projected Benefit Obligation at
End of Year $ 188 $ 87
Accumulated Benefit Obligation at
End of Year 154 70
Fair Value of Plan Assets at
End of Year $ 136 $ 61
--------------------------------------------------------------------------------
K-134
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
The components of net periodic benefit costs are as follows:
OTHER POSTRETIREMENT
PENSION BENEFITS BENEFITS
------------------------------------------------------------
Years Ended December 31,
2004 2003 2002 2004 2003 2002
----------------------------------------------------------------------------------------------------------------------
-Millions of Dollars-
COMPONENTS OF NET PERIODIC COST
Service Cost $ 6 $ 5 $ 5 $ 2 $ 2 $ 2
Interest Cost 10 9 8 3 4 4
Expected Return on Plan Assets (10) (9) (11) - - -
Prior Service Cost Amortization 2 2 2 (1) (1) -
Recognized Actuarial Loss 2 2 - 2 2 2
----------------------------------------------------------------------------------------------------------------------
Net Periodic Benefits Cost (Benefit) $ 10 $ 9 $ 4 $ 6 $ 7 $ 8
======================================================================================================================
For all pension plans, prior service costs are amortized on a straight-line
basis over the average remaining service period of employees expected to receive
benefits under the plan.
ADDITIONAL INFORMATION OTHER POSTRETIREMENT
PENSION BENEFITS BENEFITS
------------------------------------------------------------
Years Ended December 31,
2004 2003 2004 2003
----------------------------------------------------------------------------------------------------------------------
-Millions of Dollars-
Minimum Pension Liability Included in
Other Comprehensive Income $ 20 $ 3 N/A N/A
----------------------------------------------------------------------------------------------------------------------
OTHER POSTRETIREMENT
PENSION BENEFITS BENEFITS
------------------------------------------------------------
2004 2003 2004 2003
----------------------------------------------------------------------------------------------------------------------
WEIGHTED-AVERAGE ASSUMPTIONS USED TO DETERMINE
BENEFIT OBLIGATIONS AS OF DECEMBER 1,
Discount Rate 6.00 - 6.10% 6.25% 5.90% 5.50%
Rate of Compensation Increase 3.00 - 5.00% 4.00% - -
----------------------------------------------------------------------------------------------------------------------
OTHER POSTRETIREMENT
PENSION BENEFITS BENEFITS
------------------------------------------------------------
2004 2003 2004 2003
----------------------------------------------------------------------------------------------------------------------
WEIGHTED-AVERAGE ASSUMPTIONS USED TO DETERMINE
NET PERIODIC BENEFIT COST FOR YEARS ENDED
DECEMBER 31,
Discount Rate 6.25% 6.75% 5.50% 6.75%
Rate of Compensation Increase 3.00 - 5.00% 4.00% - -
Expected Return on Plan Assets 8.75% 8.75% - -
----------------------------------------------------------------------------------------------------------------------
Net periodic benefit cost is subject to various assumptions and
determinations, such as the discount rate, the rate of compensation increase,
and the expected return on plan assets. We estimated the expected return on plan
assets based on a review of the plans' asset allocations and consultations with
a third-party investment consultant and the plans' actuary considering market
and economic indicators, historical market returns, correlations and volatility,
central banks' and government treasury departments' forecasts and objectives,
and recent professional or academic research. Changes that may arise over time
with regard to these assumptions and determinations will change amounts recorded
in the future as net periodic benefit cost.
K-135
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
DECEMBER 31,
2004 2003
--------------------------------------------------------------------------------
ASSUMED HEALTH CARE COST TREND RATES
Health Care Cost Trend Rate Assumed
for Next Year 11.00% 12.10%
Ultimate Health Care Cost Trend Rate
Assumed 5.00% 5.00%
Year that the Rate Reaches the
Ultimate Trend Rate 2013 2013
--------------------------------------------------------------------------------
Assumed health care cost trend rates have a significant effect on the
amounts reported for health care plans. A one-percentage-point change in assumed
health care cost trend rates would have the following effects on the December
31, 2004 amounts:
ONE-PERCENTAGE-POINT ONE-PERCENTAGE-POINT
INCREASE DECREASE
--------------------------------------------------------------------------------
-Millions of Dollars-
Effect on Total of Service and
Interest Cost Components $ 1 $ -
Effect on Postretirement Benefit
Obligation $ 5 $ (4)
--------------------------------------------------------------------------------
PLAN ASSETS
TEP and UES calculate the market-related value of plan assets using the
fair value of plan assets on the measurement date. The UES pension plan was
initially funded during 2004. TEP and UES' pension plan asset allocations at
December 31, 2004 and TEP's pension plan asset allocations at December 31, 2003,
by asset category are as follows:
PLAN ASSETS
DECEMBER 31,
2004 2003
-------------------------------------------------------------
ASSET CATEGORY
Equity Securities 68.25% 68.1%
Debt Securities 18.23% 18.2%
Real Estate 13.52% 13.7%
Other - -
-------------------------------------------------------------
Total 100.0% 100.0%
=============================================================
TEP's investment policy for the pension plans targets a range of exposure
to the various asset classes surrounding the following allocations: equity
securities 65%, debt securities 23% and real estate 12%. TEP rebalances the
portfolio periodically when the portfolio allocation is not within the desired
range of exposure. The plan seeks to provide returns in excess of the portfolio
benchmark. The portfolio benchmark consists of the following indices: 55% S&P
500; 10% MSCI EAFE; 23% Lehman Aggregate; and 12% NCREIF. A third party
investment consultant tracks the plan's portfolio relative to the benchmark and
provides quarterly investment reviews which consist of a performance and risk
assessment on all investment managers and on the portfolio.
Certain managers within the plan use, or have authorization to use,
derivative financial instruments for risk management purposes or as a part of
their investment strategy. Currency hedges have also been used for defensive
purposes. Leverage is used by real estate managers but is limited by investment
policy.
The policy for the UES pension plan is to provide exposures to equity and
debt securities by investing in a balanced fund. As of December 31, 2004, the
fund had approximately 60% of its assets invested in stocks and 40% in fixed
income securities. The fund will hold no more than 75% of its total assets in
stocks.
CONTRIBUTIONS
TEP expects to contribute $6 million to its pension plans in 2005 and UES
expects to contribute $1 million.
K-136
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
ESTIMATED FUTURE BENEFIT PAYMENTS
The following benefit payments, which reflect future service, as
appropriate, are expected to be paid:
PENSION OTHER
BENEFITS BENEFITS
-----------------------------------------------------
-Millions of Dollars-
2005 $ 4 $ 3
2006 5 4
2007 6 4
2008 7 5
2009 8 6
Years 2010-2014 56 34
DEFINED CONTRIBUTION PLANS
TEP and UES sponsor defined contribution savings plans that are offered to
all eligible employees. Certain affiliate employees are also eligible to
participate. The plans are qualified 401(k) plans under the Internal Revenue
Code. In a defined contribution plan, the benefits a participant is to receive
result from regular contributions to a participant account. Participants direct
the investment of contributions to certain funds in their account. Matching
contributions to participant accounts are made under these plans. Matching
contributions to these plans were approximately $4 million in 2004 and $3
million in each of 2003 and 2002.
NOTE 17. STOCK-BASED COMPENSATION PLANS
----------------------------------------
Through December 31, 2004, we accounted for UniSource Energy's two
stock-based compensation plans, the Director's Plan and the Omnibus Plan, under
the recognition and measurement principles of APB 25 as allowed under FAS 123.
However, management early adopted Statement of Financial Accounting Standards
No. 123R, Share Based Payment effective January 1, 2005. See New Accounting
Standards.
The Directors' Plan provides for annual awards of non-qualified stock
options and restricted shares or stock units to each eligible director. Under
the Directors' Plan, we are authorized to grant up to a total of 324,000 shares.
The Omnibus Plan, which expired on February 3, 2004, allowed the Compensation
Committee, a committee of non-employee directors, to grant the following types
of awards to each eligible employee: stock options; stock appreciation rights;
restricted stock; stock units; performance shares; and dividend equivalents. A
total of 4.1 million shares were previously available under the Omnibus Plan
provisions.
The terminated acquisition agreement discussed in Note 2 limited the
amount of capital stock that UniSource Energy could issue under its stock plans
in 2004. Additionally, both plans contain "Change in Control" provisions that
provide for accelerated vesting of awards when certain conditions are met. The
March 29, 2004 shareholder vote to approve the proposed merger triggered 100%
vesting of all awards under the Omnibus Plan. The provision in the Directors'
Plan did not take effect as it requires consummation of a merger to accelerate
vesting.
At December 31, 2004, we had stock options, stock units, performance
shares and restricted stock grants outstanding as discussed below.
STOCK OPTIONS
No stock options were granted during 2004. We granted stock options to key
TEP and Millennium employees and members of the Board of Directors during 2003
and 2002. All stock options were granted at exercise prices equal to the market
price of the Common Stock at the grant date. Director stock options currently
vest over three years, become exercisable in one-third increments on each
anniversary date of the grant and expire on the tenth anniversary of the grant.
K-137
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
A summary of the stock option activity of the Directors' Plan and Omnibus
Plan is as follows:
2004 2003 2002
-------------------------------------------------------------------------------------------------------------------------
WEIGHTED Weighted Weighted
AVERAGE Average Average
EXERCISE Exercise Exercise
SHARES PRICE Shares Price Shares Price
-------------------------------------------------------------------------------------------------------------------------
Options Outstanding,
Beginning of Year 2,478,551 $16.04 2,572,551 $15.77 2,071,503 $15.05
Granted - - 120,236 $17.77 590,000 $18.14
Exercised (400,003) $15.29 (199,400) $13.72 (64,851) $14.42
Forfeited (2,996) $13.66 (14,836) $14.20 (24,101) $15.43
------------ ------------ -----------
Options Outstanding,
End of Year 2,075,552 $16.19 2,478,551 $16.04 2,572,551 $15.77
============ ============ ===========
Options Exercisable,
End of Year 2,053,281 $16.17 1,676,803 $15.27 1,441,829 $14.47
Exercise Price Range of Options Outstanding at December 31, 2004: $11.00 to $18.84
Weighted Average Remaining Contractual Life at December 31, 2004: 5.68 years
-------------------------------------------------------------------------------------------------------------------------
As discussed in Note 1, through December 31, 2004 we applied APB 25 in
accounting for our stock option plans. We have not recognized any compensation
cost for these options because our stock options are granted with an exercise
price equal to the market value of the stock at the grant date. We have also
adopted the disclosure-only provisions of FAS 123. We present, in Note 1, the
effect on net income and earnings per share as if the company had applied the
fair value recognition provisions of FAS 123, as required by Statement of
Financial Accounting Standards No. 148, Accounting for Stock-Based Compensation
- Transition and Disclosure.
Stock options awarded on January 1, 2002 accrue dividend equivalents that
are paid in cash on the earlier of the date of exercise of the underlying option
or the date the option expires. Compensation expense is recognized as dividends
are declared. In 2004, 2003 and 2002, we recognized compensation expense of $0.3
million for dividend equivalents on stock option grants.
RESTRICTED STOCK AND STOCK UNITS
In 2004, 2003 and 2002, we granted restricted stock awards to directors
totaling 6,480 shares, 5,157 shares and 4,644 shares, respectively. The grant
date fair value of the shares was $24.68 per share in 2004, $17.44 per share in
2003 and $19.35 per share in 2002. Directors may elect to receive stock units in
lieu of restricted shares. The restricted shares or stock units become 100%
vested on the third anniversary of the grant date. As discussed above,
Directors' awards were not affected by the shareholders' vote to approve the
proposed merger. Compensation expense equal to the fair market value on the date
of the award is recognized over the vesting period. We recorded compensation
expense of $0.1 million in 2004 and less than $0.1 million in 2003 and 2002
related to these awards.
There were no new stock unit awards granted under the Omnibus Plan in
2004, 2003 or 2002. When prior awards were granted, compensation expense equal
to the fair market value on the date of the award was recognized over a three or
four year vesting period. All stock unit awards under the Omnibus Plan were
fully vested as of March 6, 2004, and were not impacted by the shareholder vote
to approve the proposed merger. We recognized compensation expense related to
earlier awards of less than $1 million in each of the last three years.
Fully vested but undistributed stock unit awards accrue dividend
equivalent stock units based on the fair market value of common shares on the
date the dividend is paid. Compensation expense is recognized when dividends are
declared. We recorded compensation expense of $0.2 million in 2004 and 2003 for
dividend equivalent stock units.
K-138
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
PERFORMANCE SHARES
In May 2003, the Board of Directors approved a grant of performance shares
to key employees under the Omnibus Plan. The shares were to be awarded at the
end of a three-year performance period based on goal attainment. The grant date
fair value was $17.84 per share. Compensation expense was initially recorded
over the performance period based on the anticipated number and market value of
shares to be awarded. As a result of the shareholder vote to approve the
proposed merger, 53,566 performance shares vested and were distributed.
Compensation expense of $2 million was recorded in the first quarter of 2004 for
this award. Compensation expense of $0.7 million was recorded in 2003 for this
award.
NOTE 18. UNISOURCE ENERGY EARNINGS PER SHARE (EPS)
---------------------------------------------------
Basic EPS is computed by dividing net income by the weighted average
number of common shares outstanding during the period. Diluted EPS assumes that
proceeds from the hypothetical exercise of stock options and other stock-based
awards are used to repurchase outstanding shares of stock at the average fair
market price during the reporting period. The numerator in calculating both
basic and diluted EPS for each period is Net Income. The following table shows
the effects of potential dilutive common stock on the weighted average number of
shares:
Years Ended December 31,
2004 2003 2002
--------------------------------------------------------------------------------
- In Thousands-
Denominator:
Average Shares of Common Stock Outstanding 34,380 33,828 33,665
Effect of Dilutive Securities:
Warrants - - 81
Options and Stock Issuable under Employee
Benefit Plans and the Directors' Plan 661 511 476
--------------------------------------------------------------------------------
Total Shares 35,041 34,339 34,222
================================================================================
There were no antidilutive options outstanding during the year ended
December 31, 2004. Options to purchase an average of 274,000 and 525,000 shares
of Common Stock were outstanding during the years 2003 and 2002, respectively,
but were not included in the computation of diluted EPS because the options'
exercise price was greater than the average market price of the common stock.
At December 31, 2004, UniSource Energy had no outstanding warrants. There
were 4.6 million warrants that were exercisable into TEP common stock until
December 15, 2002, when they expired. The dilutive effect of these warrants was
the same as it would have been if the warrants were exercisable into UniSource
Energy Common Stock.
NOTE 19. RELATED PARTIES
-------------------------
UniSource Energy incurs corporate costs that are allocated to TEP and its
other affiliates. Certain corporate costs are directly assigned to TEP. Other
corporate costs are allocated based on a weighted-average residual allocation
factor. Management believes this method of allocation is reasonable and
approximates the cost that TEP and its other affiliates would have incurred as
stand-alone entities. Charges allocated to TEP were $12 million in 2004, $5
million in 2003 and $3 million in 2002.
TEP provides all corporate services (finance, accounting, tax, information
technology services, etc.) to UniSource Energy, UNS Gas and UNS Electric as well
as to UniSource Energy's non-utility businesses. Costs are directly assigned to
the benefiting entity where possible. Common costs are allocated on a
transaction-oriented basis. Management believes this method of allocation is
reasonable. The charges by TEP were $7 million in 2004, $5 million in 2003 and
$2 million in 2002.
Southwest Energy Solutions, Inc. (SES), a subsidiary of Millennium,
provides a supplemental workforce for TEP. Types of services provided for TEP
are dusk to dawn lighting, facilities maintenance, meter reading, solar work,
transmission and distribution, and general supplemental support. SES bills TEP
K-139
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
for providing these services. Management believes that the charges for services
are reasonable and approximates the cost that TEP would have incurred if it
performed these services directly. The charges to TEP for these services were
$13 million in 2004, $8 million in 2003 and $8 million in 2002.
Haddington Energy Partners II, LP (Haddington) funds energy-related
investments. A member of the UniSource Energy Board of Directors has an
investment in Haddington and is a managing director of the general partner of
the limited partnership. Millennium owns 31% of Haddington and accounts for this
investment under the equity method.
Valley Ventures III, LP (Valley Ventures) is a venture capital fund that
invests in information technology, microelectronics and biotechnology, primarily
within the southwestern U.S. Another member of the UniSource Energy Board of
Directors is a general partner of the company that manages the fund. Millennium
owns 15% of the fund and accounts for this investment under the equity method
due to an ability to exercise significant influence over the fund based on the
related party disclosure above.
Carboelectrica Sabinas, S. de R.L. de C.V. (Sabinas) is a Mexican
limited liability company created to develop up to 800 megawatts (MW) of
coal-fired generation in the Sabinas region of Coahuila, Mexico. Millennium owns
50% of Sabinas. Altos Hornos de Mexico, S.A. de C.V. (AHMSA) and affiliates own
the remaining 50%. UniSource Energy's Chairman, President and Chief Executive
Officer is a member of the board of directors of AHMSA. As of December 31, 2004,
Millennium's investment in Sabinas is approximately $19 million. Millennium
accounts for the investment in Sabinas under the cost method.
K-140
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
NOTE 20. SUPPLEMENTAL CASH FLOW INFORMATION
--------------------------------------------
A reconciliation of net income to net cash flows from operating activities
follows:
UNISOURCE ENERGY
----------------------------------------------
Years Ended December 31,
2004 2003 2002
----------------------------------------------
-Thousands of Dollars-
NET INCOME $45,919 $113,941 $ 34,928
ADJUSTMENTS TO RECONCILE NET INCOME
TO NET CASH FLOWS FROM OPERATING ACTIVITIES
Cumulative Effect of Accounting Change-Net of Tax - (67,471) -
Depreciation and Amortization Expense 135,315 130,643 127,923
Depreciation Recorded to Fuel and Other O&M Expense 6,175 6,230 5,701
Coal Contract Amendment Fee - - (14,248)
Amortization of Transition Recovery Asset 50,153 31,752 24,489
Net Unrealized (Gain) Loss on TEP Forward Electric Sales (1,509) 761 1,302
Net Unrealized Loss (Gain) on TEP Forward Electric Purchases 250 (378) (1,835)
Net Unrealized Gain on MEG Trading Activities (551) (1,046) (188)
Amortization of Deferred Debt-Related Costs included in
Interest Expense 5,413 2,972 2,058
Provision for Bad Debts 2,821 4,820 1,688
Deferred Income Taxes 5,303 (3,002) (8,694)
(Gain) Loss from Equity Method Investment Entities (7,326) 2,984 3,560
Gain on Sale of Real Estate (725) (467) -
Other (10,981) 46,052 (13,953)
Changes in Assets and Liabilities which Provided (Used)
Cash Exclusive of Changes Shown Separately
Accounts Receivable (13,927) (18,622) 37,591
Materials and Fuel Inventory (3,926) (7,412) (2,118)
Accounts Payable 29,531 (7,944) (35,193)
Interest Accrued 9,890 13,151 18,542
Taxes Accrued 15,684 10,353 (8,331)
Other Current Assets (49,781) (7,011) (12,199)
Other Current Liabilities 53,396 12,688 5,991
Other Deferred Credits and Other Liabilities 18,815 17,442 9,423
Deposit - Second Mortgage Indenture 17,040 (17,040) -
----------------------------------------------------------------------------------------------------------------------
NET CASH FLOWS - OPERATING ACTIVITIES $306,979 $263,396 $176,437
======================================================================================================================
K-141
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
TEP
----------------------------------------------
Years Ended December 31,
2004 2003 2002
-------------------------------------------------------------------------------------------------------------------
-Thousands of Dollars-
NET INCOME $ 46,127 $ 128,913 $ 55,390
ADJUSTMENTS TO RECONCILE NET INCOME
TO NET CASH FLOWS FROM OPERATING ACTIVITIES
Cumulative Effect of Accounting Change-Net of Tax - (67,471) -
Depreciation and Amortization Expense 117,109 121,037 124,054
Depreciation Recorded to Fuel and Other O&M Expense 6,175 6,230 5,701
Coal Contract Amendment Fee - - (14,248)
Amortization of Transition Recovery Asset 50,153 31,752 24,489
Net Unrealized (Gain) Loss on Forward Electric Sales (1,509) 761 1,302
Net Unrealized Loss (Gain) on Forward Electric Purchases 250 (378) (1,835)
Amortization of Deferred Debt-Related Costs included in
Interest Expense 5,104 2,921 2,058
Provision for Bad Debts 1,691 4,460 1,688
Deferred Income Taxes (1,011) 1,136 5,522
(Gains) Losses from Equity Method Investment Entities (168) (142) 530
Interest Accrued on Note Receivable from UniSource Energy (9,329) (10,242) (9,329)
Gain on Sale of Real Estate (725) (467) -
Other (3,219) 15,927 (250)
Changes in Assets and Liabilities which Provided (Used)
Cash Exclusive of Changes Shown Separately
Accounts Receivable (23,774) (8,717) 32,318
Materials and Fuel Inventory (1,100) (5,607) (1,331)
Accounts Payable 24,958 8,225 (35,011)
Interest Accrued 10,264 28,576 18,542
Taxes Accrued 20,031 1,281 (3,663)
Other Current Assets (5,328) 581 (12,771)
Other Current Liabilities 4,790 1,468 6,157
Other Deferred Credits and Other Liabilities 17,622 17,785 7,678
Deposit - Second Mortgage Indenture 17,040 (17,040) -
--------------------------------------------------------------------------------------------------------------------
NET CASH FLOWS - OPERATING ACTIVITIES $275,151 $ 260,989 $206,991
====================================================================================================================
Non-cash investing and financing activities of UniSource Energy and TEP
that affected recognized assets and liabilities but did not result in cash
receipts or payments were as follows:
Years Ended December 31,
2004 2003 2002
------------------------------------------------------------------------
-Thousands of Dollars-
Capital Lease Obligations $ 12,273 $ 10,731 $ 11,604
------------------------------------------------------------------------
The non-cash change in capital lease obligations represents interest
accrued for accounting purposes in excess of interest payments in 2004, 2003,
and 2002.
On August 11, 2003, UniSource Energy acquired the Arizona gas and
electric system assets from Citizens for $223 million, comprised of the base
purchase price plus other operating capital adjustments and transaction costs.
In conjunction with the acquisition, liabilities were assumed as follows:
K-142
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
- Thousands of Dollars -
--------------------------------------------------------------------
Fair Value of Assets Acquired $262,044
Liabilities Assumed 38,648
--------------------------------------------------------------------
Assets/Liabilities Purchased $223,396
====================================================================
Cash Paid for Citizens Assets $218,558
Transaction Costs 4,838
--------------------------------------------------------------------
Total Purchase Price $223,396
====================================================================
NOTE 21. QUARTERLY FINANCIAL DATA (UNAUDITED)
----------------------------------------------
Our quarterly financial information has not been audited but, in
management's opinion, includes all adjustments necessary for a fair
presentation. Our utility businesses are seasonal in nature with peak sales
periods for TEP and UNS Electric generally occurring during the summer months
and peak sales periods for UNS Gas generally occurring during the winter months.
Accordingly, comparisons among quarters of a year may not represent overall
trends and changes in operations.
UNISOURCE ENERGY
-------------------------------------------------------------
FIRST SECOND THIRD FOURTH
-------------------------------------------------------------
-Thousands of Dollars-
(except per share data)
2004
Operating Revenue $270,084 $290,081 $335,309 $273,504
Operating Income 42,710 61,571 75,461 39,648
Net Income 6,421 12,801 23,799 2,898
Basic EPS $0.19 $0.37 $0.69 $0.08
Diluted EPS $0.18 $0.37 $0.68 $0.08
2003
Operating Revenue $172,247 $216,073 $304,252 $280,183
Operating Income 12,069 46,981 83,719 60,236
Income (Loss) Before Cumulative Effect of Accounting Change (15,125) 6,920 27,376 27,299
Cumulative Effect of Accounting Change - Net of Tax 67,471 - - -
Net Income 52,346 6,920 27,376 27,299
Basic EPS:
----------
Income (Loss) Before Cumulative Effect of Accounting Change $(0.45) $0.20 $0.81 $0.81
Cumulative Effect of Accounting Change - Net of Tax 2.00 - - -
Net Income 1.55 0.20 0.81 0.81
Diluted EPS:
------------
Income (Loss) Before Cumulative Effect of Accounting Change (0.45) 0.20 0.80 0.79
Cumulative Effect of Accounting Change - Net of Tax 2.00 - - -
Net Income 1.55 0.20 0.80 0.79
K-143
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONCLUDED)
TEP
-------------------------------------------------------------
FIRST SECOND THIRD FOURTH
-------------------------------------------------------------
-Thousands of Dollars-
2004
Operating Revenue $186,974 $233,742 $272,085 $196,497
Operating Income 35,688 62,269 74,531 34,196
Interest Income - Note Receivable from UniSource Energy 2,320 2,319 2,345 2,345
Net Income 794 18,017 26,222 1,094
2003
Operating Revenues $171,627 $214,688 $265,871 $199,365
Operating Income 19,641 55,825 87,015 48,517
Interest Income - Note Receivable from UniSource Energy 2,525 2,554 2,581 2,582
Income (Loss) Before Cumulative Effect of Accounting Change (8,100) 13,511 32,194 23,837
Cumulative Effect of Accounting Change - Net of Tax 67,471 - - -
Net Income 59,371 13,511 32,194 23,837
EPS is computed independently for each of the quarters presented. Therefore, the
sum of the quarterly EPS amounts may not equal the total for the year.
The principal unusual items for TEP and UniSource Energy include:
TEP AND UNISOURCE ENERGY
o FOURTH QUARTER 2004: UniSource Energy recorded a $7 million
pre-tax acquisition termination fee of which 77% was allocated to
TEP. See Note 2. UniSource Energy recognized a current income tax
benefit of $1.1 million as a result of deducting certain
acquisition-related legal and advisory fees that had previously
been treated as permanently nondeductible expenses, 77% of which
was recognized by TEP. TEP recorded a $2 million pre-tax net
cumulative reduction of previously overstated depreciation and
interest expense related to a capitalized lease transaction. See
Notes 9 and 10. TEP recognized a $1 million income tax expense due to
the uncertainty of future use of certain ITC carryforwards. See Note
15.
o FIRST QUARTER 2003: TEP recorded an after-tax gain of $67 million
for the cumulative effect of adopting FAS 143. See Note 5.
o FOURTH QUARTER 2003: TEP recognized a $15 million tax benefit due
to a reduction in its NOL valuation allowance. See Note 15.
UniSource Energy recorded $3 million of acquisition-related fees,
80% of which were allocated to TEP. These fees did not result in
a current tax deduction. See Note 15.
UNISOURCE ENERGY
o FIRST QUARTER 2004: MEH recognized a $3.1 million after-tax gain
from the sale of Sago Energy, LP's operating subsidiaries, a
Haddington investment.
o FOURTH QUARTER 2003: UED recognized an $11 million pre-tax
development fee for closing the Springerville expansion project.
See Note 14. This quarter also includes the first full quarter of
activity for UES which was established on August 11, 2003. UES
contributed Operating Revenues of $69 million, Operating Income
of $7 million and Net Income of $3 million to fourth quarter
results.
K-144
UNISOURCE ENERGY
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
ADDITIONS-
BEGINNING CHARGED TO ENDING
DESCRIPTION BALANCE INCOME DEDUCTIONS BALANCE
--------------------------------------------------------------------------------------------
Year Ended December 31, -Millions of Dollars-
Deferred Tax Assets Valuation Allowance (1)
2004 $ 7 $ 1 $ - $ 8
2003 22 - 15 7
2002 16 7 1 22
Allowance for Doubtful Accounts (2)
2004 $ 12 $ 7 $ 2 $ 17
2003 9 5 2 12
2002 9 2 2 9
--------------------------------------------------------------------------------------------
(1) The deferred tax assets valuation allowance reduces the deferred tax asset
balance. It relates to NOL and ITC carryforward amounts. UniSource, TEP and
Subsidiaries charged $1 million to income in 2004 related to TEP's ITC
carryforwards that may not be utilized prior to their expiration. UniSource, TEP
and Subsidiaries reduced the deferred tax assets valuation in 2003 primarily
based on guidance issued by the Internal Revenue Service in September, 2003 (see
Note 15 of Notes to Consolidated Financial Statements). UniSource, TEP and
Subsidiaries charged approximately $7 million to income in 2002 relating to the
limitation on the utilization of operating losses generated by certain
Millennium entities. UniSource, TEP and Subsidiaries reduced the deferred tax
assets valuation in 2002 due to the settlement of Internal Revenue Service
audits.
(2) TEP and UES record additions to the Allowance for Doubtful accounts based on
historical experience and any specific customer collection issues identified.
Deductions principally reflect amounts charged off as uncollectible, less
amounts recovered. Balances related primarily to TEP reserves for sales to the
CPX and CISO in 2000 and 2001. See Note 13 of Notes to Consolidated Financial
Statements.
K-145
TEP
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
ADDITIONS-
BEGINNING CHARGED TO ENDING
DESCRIPTION BALANCE INCOME DEDUCTIONS BALANCE
--------------------------------------------------------------------------------------------
Year Ended December 31, -Millions of Dollars-
Deferred Tax Assets Valuation Allowance (1)
2004 $ - $ 1 $ - $ 1
2003 15 - 15 -
2002 16 - 1 15
Allowance for Doubtful Accounts (2)
2004 $11 $ 5 $ 2 $ 14
2003 9 5 3 11
2002 9 2 2 9
-------------------------------------------------------------------------------------------
(1) The deferred tax assets valuation allowance reduces the deferred tax asset
balance. It relates to NOL and ITC carryforward amounts. TEP charged $1 million
to income in 2004 related to ITC carryforwards that may not be utilized prior to
their expiration. TEP reduced the deferred tax assets valuation in 2003
primarily based on guidance issued by the Internal Revenue Service in September,
2003 (see Note 15 of Notes to Consolidated Financial Statements). TEP reduced
the deferred tax assets valuation in 2002 due to the settlement of Internal
Revenue Service audits.
(2) TEP recorded $7 million of expense in the first quarter of 2001 and $9
million in the fourth quarter of 2000 to reserve for uncollectible amounts
related to sales to the state of California in 2000 and the first quarter of
2001. TEP reversed $8 million of the $16 million reserve in the fourth quarter
of 2001. In the first quarter of 2003, TEP increased its reserve for sales to
the CPX and the CISO by $2 million by recording a reduction of wholesale
revenues. In the second quarter of 2004, TEP increased its reserve for sales to
the CPX and the CISO by an additional $3 million based on new FERC orders.
Deductions principally reflect amounts charged off as uncollectible, less
amounts recovered (see Note 13 of Notes to Consolidated Financial Statements).
K-146
ITEM 9. - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
--------------------------------------------------------------------------------
None.
ITEM 9A. - CONTROLS AND PROCEDURES
--------------------------------------------------------------------------------
UniSource Energy and TEP's Chief Executive Officer and Chief Financial
Officer supervised and participated in UniSource Energy and TEP's evaluation of
their disclosure controls and procedures as of December 31, 2004. Disclosure
controls and procedures are controls and procedures designed to ensure that
information required to be disclosed in UniSource Energy and TEP's periodic
reports filed or submitted under the Securities Exchange Act of 1934, as
amended, is recorded, processed, summarized and reported within the time periods
specified in the Securities and Exchange Commission's rules and forms. These
disclosure controls and procedures can only provide reasonable, not absolute,
assurance that the above objectives have been met. Based upon the evaluation
performed, UniSource Energy and TEP's Chief Executive Officer and Chief
Financial Officer concluded that UniSource Energy and TEP's disclosure controls
and procedures are effective.
While UniSource Energy and TEP continually strive to improve their
disclosure controls and procedures to enhance the quality of their financial
reporting, there has been no change in UniSource Energy or TEP's internal
control over financial reporting during the fourth quarter of 2004, that has
materially affected, or is reasonably likely to materially affect, UniSource
Energy or TEP's internal control over financial reporting.
UniSource Energy's Management's Report on Internal Control Over Financial
Reporting Under 404 of Sarbanes-Oxley appears as the first report under Item 8
and the Report of Independent Registered Public Accounting Firm appears as the
second report under Item 8 in this Annual Report on Form 10-K.
ITEM 9B. - OTHER INFORMATION
--------------------------------------------------------------------------------
In December 1998, TEP entered into change in control agreements (the
"Agreements") with all of the officers of TEP. As of March 1, 2005, the
Agreements were in effect with respect to the following officers: Thomas A.
Delawder, Michael DeConcini, Steven J. Glaser, Thomas N. Hansen, Karen G.
Kissinger, Kevin P. Larson, Steven W. Lynn, Dennis R. Nelson, Vincent Nitido Jr.
and James S. Pignatelli.
The Agreements provide that each officer shall be employed by TEP, or one
of its subsidiaries or affiliates, in a position comparable to his or her
current position, with compensation and benefits, which are at least equal to
their then current compensation and benefits, for a period of five years after a
change in control (subject to earlier termination due to the officer's
acceptance of a position with another company or termination for cause). In the
event that the officer's employment is terminated by TEP (with the exception of
termination due to the officer's acceptance of another position or for cause),
or if the officer terminates employment because of a reduction in position,
responsibility, compensation or for certain other stated reasons, the officer is
entitled to certain severance benefits. Under the terms of the Agreements, the
approval by UniSource Energy's shareholders at the March 29, 2004 special
meeting of the proposed acquisition of all of UniSource Energy's outstanding
Common Stock by Saguaro constituted a change of control.
On March 3, 2005, TEP provided the officers with respect to which the
Agreements were in effect at that time, written notice of the termination of the
Agreements. Pursuant to the terms of the Agreements, the termination will become
effective on March 3, 2010, the fifth anniversary of the date of the written
notice of termination.
ITEM 10. - DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANTS
--------------------------------------------------------------------------------
DIRECTORS
---------
Certain of the individuals serving as Directors of UniSource Energy also
serve as the Directors of TEP. Information concerning Directors will be
contained under Election of Directors in UniSource Energy's Proxy Statement
relating to the 2005 Annual Meeting of Shareholders, which will be filed with
the SEC not later than 120 days after December 31, 2004, which information is
incorporated herein by reference.
EXECUTIVE OFFICERS - UNISOURCE ENERGY
-------------------------------------
Executive Officers of UniSource Energy, who are elected annually by
UniSource Energy's Board of Directors, are as follows:
EXECUTIVE
OFFICER
NAME AGE POSITION(S) HELD SINCE
--------------------------------------------------------------------------------
James S. Pignatelli 61 Chairman, President and
Chief Executive Officer 1998
Michael J. DeConcini 40 Senior Vice President, Investments
and Planning 1999
Dennis R. Nelson 54 Senior Vice President, Utility
Services 1998
Karen G. Kissinger 50 Vice President, Controller and
Chief Compliance Officer 1998
Kevin P. Larson 48 Vice President, Chief Financial
Officer and Treasurer 2000
Steven W. Lynn 58 Vice President, Communications
and Government Relations 2003
Vincent Nitido, Jr. 49 Vice President, General Counsel
and Chief Administrative Officer 2000
Catherine A. Nichols 46 Corporate Secretary 2003
--------------------------------------------------------------------------------
K-147
JAMES S. PIGNATELLI Mr. Pignatelli joined TEP as Senior Vice President
in August 1994 and was elected Senior Vice President
and Chief Operating Officer in 1996. He was named
Senior Vice President and Chief Operating Officer of
UniSource Energy in January 1998, and Executive Vice
President and Chief Operating Officer of TEP in
March 1998. On June 23, 1998, Mr. Pignatelli was
named Chairman, President and CEO of UniSource
Energy and TEP. Prior to joining TEP, he was
President and Chief Executive Officer from 1988 to
1993 of Mission Energy Company, a subsidiary of SCE
Corp.
MICHAEL J. DECONCINI Mr. DeConcini joined TEP in 1988 and served in
various positions in finance, strategic planning and
wholesale marketing. He was Manager of TEP's
Wholesale Marketing Department in 1994, adding
Product Development and Business Development in
1997. In November 1998, he was elected Vice
President of MEH, and elected Vice President,
Strategic Planning of UniSource Energy in February
1999. He was named Senior Vice President,
Investments and Planning of UniSource Energy in
October 2000. Mr. DeConcini was elected Senior Vice
President and Chief Operating Officer of the Energy
Resources business unit of TEP, effective January 1,
2003.
DENNIS R. NELSON Mr. Nelson joined TEP as a staff attorney in 1976.
He was manager of the Legal Department from 1985 to
1990. He was elected Vice President, General Counsel
and Corporate Secretary in January 1991. He was
named Vice President, General Counsel and Corporate
Secretary of UniSource Energy in January 1998. Mr.
Nelson was named Senior Vice President and General
Counsel of TEP in November 1998. In December 1998,
he was named Chief Operating Officer, Corporate
Services of TEP. In October 2000, he was named
Senior Vice President, Governmental Affairs of
UniSource Energy and Senior Vice President and Chief
Operating Officer of the Energy Resources business
unit of TEP. Mr. Nelson was elected Senior Vice
President of Utility Services, effective January 1,
2003 and named Chief Operating Officer of UES on
August 11, 2003.
KAREN G. KISSINGER Ms. Kissinger joined TEP as Vice President and
Controller in January 1991. She was named Vice
President, Controller and Principal Accounting
Officer of UniSource Energy in January 1998. In
November 1998, Ms. Kissinger was also named Chief
Information Officer of TEP. She was named Chief
Compliance Officer of UniSource Energy and TEP,
effective January 1, 2003.
KEVIN P. LARSON Mr. Larson joined TEP in 1985 and thereafter held
various positions in its finance department and at
TEP's investment subsidiaries. In January 1991, he
was elected Assistant Treasurer of TEP and named
Manager of Financial Programs. He was elected
Treasurer of TEP in August 1994 and Vice President
in March 1997. In October 2000, he was elected Vice
President and Chief Financial Officer of both
UniSource Energy and TEP and remains Treasurer of
both organizations.
STEVEN W. LYNN Mr. Lynn joined TEP in 2000 as Manager of Corporate
Relations for UniSource Energy and was named Manager
of Corporate Relations of both TEP and UniSource
Energy during 2000. In January 2003, he was elected
Vice President of Communications and Government
Relations at UniSource Energy and TEP. Prior to
joining TEP, Mr. Lynn was an owner-partner from 1984
- 2000 of Nordensson Lynn & Associates, Inc., a
Tucson-based advertising, marketing and public
relations firm.
VINCENT NITIDO, JR. Mr. Nitido joined TEP as a staff attorney in 1991.
He was promoted to Manager of the Legal Department
in 1994, and elected Vice President and Assistant
General Counsel in 1998. In October 2000, he was
elected Vice President, General Counsel of both
UniSource Energy and TEP and Corporate Secretary of
UniSource Energy. Mr. Nitido was also named Chief
Administrative Officer of UniSource Energy and TEP,
effective January 1, 2003.
CATHERINE A. NICHOLS Ms. Nichols joined TEP as a staff attorney in 1989.
She was promoted to Manager of the Legal Department
and elected Corporate Secretary of TEP in 1998. She
assumed the additional role of Manager of the Human
Resources Department in 1999. Ms. Nichols was
elected Corporate Secretary of UniSource Energy,
effective January 1, 2003, and remains Corporate
Secretary of TEP.
K-148
EXECUTIVE OFFICERS - TUCSON ELECTRIC POWER COMPANY
--------------------------------------------------
Executive Officers of TEP, who are elected annually by TEP's Board of
Directors, are:
EXECUTIVE
OFFICER
NAME AGE POSITION(S) HELD SINCE
--------------------------------------------------------------------------------
James S. Pignatelli 61 Chairman, President and
Chief Executive Officer 1994
Michael J. DeConcini 40 Senior Vice President, Energy
Resources Business Unit 2003
Steven J. Glaser 47 Senior Vice President and
Chief Operating Officer,
Transmission and Distribution
Business Unit 1994
Thomas A. Delawder 58 Vice President, Energy Resources
Business Unit 1985
Thomas N. Hansen 54 Vice President / Technical Advisor 1992
Karen G. Kissinger 50 Vice President, Controller and Chief
Compliance Officer 1991
Kevin P. Larson 48 Vice President, Chief Financial
Officer and Treasurer 1994
Steven W. Lynn 58 Vice President, Communications and
Government Relations 2003
Vincent Nitido, Jr. 49 Vice President, General Counsel
and Chief Administrative Officer 1998
Catherine A. Nichols 46 Corporate Secretary 1998
--------------------------------------------------------------------------------
JAMES S. PIGNATELLI See description shown under UniSource Energy
Corporation above.
MICHAEL J. DECONCINI See description shown under UniSource Energy
Corporation above.
STEVEN J. GLASER Mr. Glaser joined TEP in 1990 as a Senior Attorney
in charge of Regulatory Affairs. He was Manager of
TEP's Legal Department from 1992 to 1994, and
Manager of Contracts and Wholesale Marketing from
1994 until elected Vice President, Business
Development. In 1995, he was named Vice President,
Wholesale/Retail Pricing and System Planning. He was
named Vice President, Energy Services in 1996 and
Vice President, Rates and Regulatory Support and
Utility Distribution Company Energy Services in
November 1998. In October 2000, he was named Senior
Vice President and Chief Operating Officer of the
Transmission and Distribution business unit.
THOMAS A. DELAWDER Mr. Delawder joined TEP in 1974 and thereafter
served in various engineering and operations
positions. In April 1985, he was named Manager,
Systems Operations and was elected Vice President,
Power Supply and System Control in November 1985. In
February 1991, he became Vice President, Engineering
and Power Supply and in January 1992 he became Vice
President, System Operations. In 1994, he became
Vice President of the Energy Resources business
unit. Mr. Delawder has submitted his intent to
retire, after 30 years of service, effective April
1, 2005.
THOMAS N. HANSEN Mr. Hansen joined TEP in December 1992 as Vice
President, Power Production. Prior to joining TEP,
Mr. Hansen was Century Power Corporation's Vice
President, Operations from 1989 and Plant Manager at
Springerville from 1987 through 1988. In 1994, he
was named Vice President / Technical Advisor.
KAREN G. KISSINGER See description shown under UniSource Energy
Corporation above.
KEVIN P. LARSON See description shown under UniSource Energy
Corporation above.
STEVEN W. LYNN See description shown under UniSource Energy
Corporation above.
VINCENT NITIDO, JR. See description shown under UniSource Energy
Corporation above.
CATHERINE A. NICHOLS See description shown under UniSource Energy
Corporation above.
Information required by Items 405 and 406 of SEC Regulation S-K will be
included in UniSource Energy's Proxy Statement relating to the 2005 Annual
Meeting of Shareholders, which will be filed with the SEC not later than 120
days after December 31, 2004, which information is incorporated herein by
reference.
K-149
ITEM 11. - EXECUTIVE COMPENSATION
--------------------------------------------------------------------------------
Information concerning Executive Compensation will be contained under
Executive Compensation and Other Information in UniSource Energy's Proxy
Statement relating to the 2005 Annual Meeting of Shareholders, which will be
filed with the SEC not later than 120 days after December 31, 2004, which
information is incorporated herein by reference.
ITEM 12. - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
--------------------------------------------------------------------------------
GENERAL
At March 11, 2005, UniSource Energy had outstanding 34.5 million shares of
Common Stock. As of March 11, 2005, the number of shares of Common Stock
beneficially owned by all directors and officers of UniSource Energy as a group
amounted to approximately 6% of the outstanding Common Stock.
At March 11, 2005, UniSource Energy owned greater than 99.9% of the
outstanding shares of common stock of TEP.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS
Information concerning the security ownership of certain beneficial owners
of UniSource Energy will be contained under Security Ownership of Certain
Beneficial Owners in UniSource Energy's Proxy Statement relating to the 2005
Annual Meeting of Shareholders, which will be filed with the SEC not later than
120 days after December 31, 2004, which information is incorporated herein by
reference.
SECURITY OWNERSHIP OF MANAGEMENT
Information concerning the security ownership of the Directors and
Executive Officers of UniSource Energy and TEP will be contained under Security
Ownership of Management in UniSource Energy's Proxy Statement relating to the
2005 Annual Meeting of Shareholders, which will be filed with the SEC not later
than 120 days after December 31, 2004, which information is incorporated herein
by reference.
SECURITIES AUTHORIZED FOR ISSUANCE UNDER EQUITY COMPENSATION PLANS
Information concerning securities authorized for issuance under equity
compensation plans will be contained under Securities Authorized for Issuance
under Equity Compensation Plans in UniSource Energy's Proxy Statement relating
to the 2005 Annual Meeting of Shareholders, which will be filed with the SEC not
later than 120 days after December 31, 2004, which information is incorporated
herein by reference.
ITEM 13. - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
--------------------------------------------------------------------------------
Information concerning certain relationships and related transactions of
UniSource Energy and TEP will be contained under Transactions with Management
and Others and Compensation Committee Interlocks and Insider Participation in
UniSource Energy's Proxy Statement relating to the 2005 Annual Meeting of
Shareholders, which will be filed with the SEC not later than 120 days after
December 31, 2004, which information is incorporated herein by reference.
ITEM 14. - PRINCIPAL ACCOUNTANT FEES AND SERVICES
--------------------------------------------------------------------------------
Information concerning principal accountant fees and services will be
contained in UniSource Energy's Proxy Statement relating to the 2005 Annual
Meeting of Shareholders, which will be filed with the SEC not later than 120
days after December 31, 2004, which information is incorporated herein by
reference.
K-150
PART IV
ITEM 15. - EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
--------------------------------------------------------------------------------
Page
----
(a) 1. Consolidated Financial Statements as of December 31, 2004
and 2003 and for Each of the Three Years in the Period
Ended December 31, 2004
UNISOURCE ENERGY CORPORATION
Report of Independent Registered Public Accounting Firm 69
Consolidated Statements of Income 70
Consolidated Statements of Cash Flows 71
Consolidated Balance Sheets 72
Consolidated Statements of Capitalization 73
Consolidated Statements of Changes in Stockholders' Equity 74
Notes to Consolidated Financial Statements 80
TUCSON ELECTRIC POWER COMPANY
Report of Independent Registered Public Accounting Firm 69
Consolidated Statements of Income 75
Consolidated Statements of Cash Flows 76
Consolidated Balance Sheets 77
Consolidated Statements of Capitalization 78
Consolidated Statements of Changes in Stockholders' Equity 79
Notes to Consolidated Financial Statements 80
2. Financial Statement Schedule
Schedule II
Valuation and Qualifying Accounts 133
3. Exhibits
Reference is made to the Exhibit Index commencing on page 144.
K-151
SIGNATURES
Pursuant to the requirements of Section 13 and 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
UNISOURCE ENERGY CORPORATION
Date: March 16, 2005 By: /s/ Kevin P. Larson
-----------------------------------------
Kevin P. Larson
Vice President and Principal
Financial Officer
Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
Date: March 16, 2005 /s/ James S. Pignatelli*
-----------------------------------------
James S. Pignatelli
Chairman of the Board, President
and Principal Executive Officer
Date: March 16, 2005 /s/ Kevin P. Larson
-----------------------------------------
Kevin P. Larson
Principal Financial Officer
Date: March 16, 2005 /s/ Karen G. Kissinger*
-----------------------------------------
Karen G. Kissinger
Principal Accounting Officer
Date: March 16, 2005 /s/ Lawrence J. Aldrich*
-----------------------------------------
Lawrence J. Aldrich
Director
Date: March 16, 2005 /s/ Larry W. Bickle*
-----------------------------------------
Larry W. Bickle
Director
Date: March 16, 2005 /s/ Elizabeth T. Bilby*
-----------------------------------------
Elizabeth T. Bilby
Director
Date: March 16, 2005 /s/ Harold W. Burlingame*
-----------------------------------------
Harold W. Burlingame
Director
Date: March 16, 2005 /s/ John L. Carter*
-----------------------------------------
John L. Carter
Director
Date: March 16, 2005 /s/ Robert A. Elliott*
-----------------------------------------
Robert A. Elliott
Director
K-152
Date: March 16, 2005 /s/ Kenneth Handy*
-----------------------------------------
Kenneth Handy
Director
Date: March 16, 2005 /s/ Warren Y. Jobe*
-----------------------------------------
Warren Y. Jobe
Director
Date: March 16, 2005 * By: /s/ Kevin P. Larson
-----------------------------------------
Kevin P. Larson
As attorney-in-fact for each
of the persons indicated
K-153
SIGNATURES
----------
Pursuant to the requirements of Section 13 and 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
TUCSON ELECTRIC POWER COMPANY
Date: March 16, 2005 By: /s/ Kevin P. Larson
-----------------------------------------
Kevin P. Larson
Vice President and Principal
Financial Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
Date: March 16, 2005 /s/ James S. Pignatelli*
-----------------------------------------
James S. Pignatelli
Chairman of the Board, President
and Principal Executive Officer
Date: March 16, 2005 /s/ Kevin P. Larson
-----------------------------------------
Kevin P. Larson
Principal Financial Officer
Date: March 16, 2005 /s/ Karen G. Kissinger*
-----------------------------------------
Karen G. Kissinger
Principal Accounting Officer
Date: March 16, 2005 /s/ Lawrence J. Aldrich*
-----------------------------------------
Lawrence J. Aldrich
Director
Date: March 16, 2005 /s/ Elizabeth T. Bilby*
-----------------------------------------
Elizabeth T. Bilby
Director
Date: March 16, 2005 /s/ Harold W. Burlingame*
-----------------------------------------
Harold W. Burlingame
Director
Date: March 16, 2005 /s/ John L. Carter*
-----------------------------------------
John L. Carter
Director
Date: March 16, 2005 /s/ Robert A. Elliott*
-----------------------------------------
Robert A. Elliott
Director
K-154
Date: March 16, 2005 /s/ Kenneth Handy*
-----------------------------------------
Kenneth Handy
Director
Date: March 16, 2005 /s/ Warren Y. Jobe*
-----------------------------------------
Warren Y. Jobe
Director
Date: March 16, 2005 * By: /s/ Kevin P. Larson
-----------------------------------------
Kevin P. Larson
As attorney-in-fact for each
of the persons indicated
K-155
EXHIBIT INDEX
-------------
*2(a) -- Agreement and Plan of Exchange, dated as of March 20, 1995,
between TEP, UniSource Energy and NCR Holding, Inc.
*2(b) -- Agreement and Plan of Merger between UniSource Energy
Corporation and Saguaro Acquisition Corp., dated as of
November 21, 2003. (Form 8-K dated November 21, 2003, File
No. 1-13739 -- Exhibit 10.)
*3(a) -- Restated Articles of Incorporation of TEP, filed with the ACC on
August 11, 1994, as amended by Amendment to Article Fourth of
our Restated Articles of Incorporation, filed with the ACC on
May 17, 1996. (Form 10-K for year ended December 31, 1996,
File No. 1-5924 -- Exhibit 3(a).)
*3(b) -- Bylaws of TEP, as amended May 20, 1994. (Form 10-Q for the
quarter ended June 30, 1994, File No. 1-5924 -- Exhibit 3.)
*3(c) -- Amended and Restated Articles of Incorporation of UniSource
Energy. (Form 8-A/A, dated January 30, 1998, File No. 1-13739
-- Exhibit 2(a).)
*3(d) -- Bylaws of UniSource Energy, as amended December 11, 1997. (Form
8-A, dated December 23, 1997, File No. 1-13739 -- Exhibit 2(b).)
*4(a)(1) -- Indenture dated as of April 1, 1941, to The Chase National Bank
of the City of New York, as Trustee. (Form S-7, File No. 2-59906
-- Exhibit 2(b)(1).)
*4(a)(2) -- First Supplemental Indenture, dated as of October 1, 1946.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(2).)
*4(a)(3) -- Second Supplemental Indenture dated as of October 1, 1947.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(3).)
*4(a)(4) -- Third Supplemental Indenture, dated as of April 1, 1949. (Form
S-7, File No. 2-59906 -- Exhibit 2(b)(4).)
*4(a)(5) -- Fourth Supplemental Indenture, dated as of December 1, 1952.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(5).)
*4(a)(6) -- Fifth Supplemental Indenture, dated as of January 1, 1955.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(6).)
*4(a)(7) -- Sixth Supplemental Indenture, dated as of January 1, 1958.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(7).)
*4(a)(8) -- Seventh Supplemental Indenture, dated as of November 1, 1959.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(8).)
*4(a)(9) -- Eighth Supplemental Indenture, dated as of November 1, 1961.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(9).)
*4(a)(10) -- Ninth Supplemental Indenture, dated as of February 20, 1964.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(10).)
*4(a)(11) -- Tenth Supplemental Indenture, dated as of February 1, 1965.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(11).)
*4(a)(12) -- Eleventh Supplemental Indenture, dated as of February 1, 1966.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(12).)
K-156
*4(a)(13) -- Twelfth Supplemental Indenture, dated as of November 1, 1969.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(13).)
*4(a)(14) -- Thirteenth Supplemental Indenture, dated as of January 20, 1970.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(14).)
*4(a)(15) -- Fourteenth Supplemental Indenture, dated as of September 1, 1971.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(15).)
*4(a)(16) -- Fifteenth Supplemental Indenture, dated as of March 1, 1972.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(16).)
*4(a)(17) -- Sixteenth Supplemental Indenture, dated as of May 1, 1973. (Form
S-7, File No. 2-59906 -- Exhibit 2(b)(17).)
*4(a)(18) -- Seventeenth Supplemental Indenture, dated as of November 1, 1975.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(18).)
*4(a)(19) -- Eighteenth Supplemental Indenture, dated as of November 1, 1975.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(19).)
*4(a)(20) -- Nineteenth Supplemental Indenture, dated as of July 1, 1976.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(20).)
*4(a)(21) -- Twentieth Supplemental Indenture, dated as of October 1, 1977.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(21).)
*4(a)(22) -- Twenty-first Supplemental Indenture, dated as of November 1,
1977. (Form 10-K for year ended December 31, 1980, File No.
1-5924 -- Exhibit 4(v).)
*4(a)(23) -- Twenty-second Supplemental Indenture, dated as of January 1,
1978. (Form 10-K for year ended December 31, 1980, File No.
1-5924 -- Exhibit 4(w).)
*4(a)(24) -- Twenty-third Supplemental Indenture, dated as of July 1, 1980.
(Form 10-K for year ended December 31, 1980, File No. 1-5924 --
Exhibit 4(x).)
*4(a)(25) -- Twenty-fourth Supplemental Indenture, dated as of October 1,
1980. (Form 10-K for year ended December 31, 1980, File No.
1-5924 -- Exhibit 4(y).)
*4(a)(26) -- Twenty-fifth Supplemental Indenture, dated as of April 1, 1981.
(Form 10-Q for quarter ended March 31, 1981, File No. 1-5924 --
Exhibit 4(a).)
*4(a)(27) -- Twenty-sixth Supplemental Indenture, dated as of April 1, 1981.
(Form 10-Q for quarter ended March 31, 1981, File No. 1-5924 --
Exhibit 4(b).)
*4(a)(28) -- Twenty-seventh Supplemental Indenture, dated as of October 1,
1981. (Form 10-Q for quarter ended September 30, 1982, File No.
1-5924 -- Exhibit 4(c).)
*4(a)(29) -- Twenty-eighth Supplemental Indenture, dated as of June 1, 1990.
(Form 10-Q for quarter ended June 30, 1990, File No. 1-5924 --
Exhibit 4(a)(1).)
*4(a)(30) -- Twenty-ninth Supplemental Indenture, dated as of December 1,
1992. (Form S-1, Registration No. 33-55732 -- Exhibit 4(a)(30).)
*4(a)(31) -- Thirtieth Supplemental Indenture, dated as of December 1, 1992.
(Form S-1, Registration No. 33-55732 -- Exhibit 4(a)(31).)
*4(a)(32) -- Thirty-first Supplemental Indenture, dated as of May 1, 1996.
(Form 10-K for the year ended December 31, 1996, File No. 1-5924
-- Exhibit 4(a)(32).)
K-157
*4(a)(33) -- Thirty-second Supplemental Indenture, dated as of May 1, 1996.
(Form 10-K for the year ended December 31, 1996, File No. 1-5924
-- Exhibit 4(a)(33).)
*4(a)(34) -- Thirty-third Supplemental Indenture, dated as of May 1, 1998.
(Form 10-Q for the quarter ended June 30, 1998, File No. 1-5924
-- Exhibit 4(a).)
*4(a)(35) -- Thirty-fourth Supplemental Indenture, dated as of August 1, 1998.
(Form 10-Q for the quarter ended June 30, 1998, File No. 1-5924
-- Exhibit 4(b).)
*4(b)(1) -- Installment Sale Agreement, dated as of December 1, 1973, among
the City of Farmington, New Mexico, Public Service Company of New
Mexico and TEP. (Form 8-K for the month of January 1974, file No.
0-269 -- Exhibit 3.)
*4(b)(2) -- Ordinance No. 486, adopted December 17, 1973, of the City of
Farmington, New Mexico. (Form 8-K for the month of January 1974,
File No. 0-269 -- Exhibit 4.)
*4(b)(3) -- Amended and Restated Installment Sale Agreement dated as of April
1, 1997, between the City of Farmington, New Mexico and TEP
relating to Pollution Control Revenue bonds, 1997 Series A
(Tucson Electric Power Company San Juan Project). (Form 10-Q for
the quarter ended March 31,1997, File No. 1-5924 -- Exhibit
4(a).)
*4(b)(4) -- City of Farmington, New Mexico Ordinance No. 97-1055, adopted
April 17, 1997, authorizing Pollution Control Revenue bonds, 1997
Series A (Tucson Electric Power Company San Juan Project). (Form
10-Q for the quarter ended March 31, 1997, File No. 1-5924 --
Exhibit 4(b).)
*4(c)(1) -- Loan Agreement, dated as of October 1, 1982, between the Pima
County Authority and TEP relating to Floating Rate Monthly Demand
Industrial Development Revenue Bonds, 1982 Series A (Tucson
Electric Power Company Sundt Project). (Form 10-Q for the quarter
ended September 30, 1982, File No. 1-5924 -- Exhibit 4(a).)
*4(c)(2) -- Indenture of Trust, dated as of October 1, 1982, between the Pima
County Authority and Morgan Guaranty authorizing Floating Rate
Monthly Demand Industrial Development Revenue Bonds, 1982 Series
A (Tucson Electric Power Company Sundt Project). (Form 10-Q for
the quarter ended September 30, 1982, File No. 1-5924 -- Exhibit
4(b).)
*4(c)(3) -- First Supplemental Loan Agreement, dated as of March 31, 1992,
between the Pima County Authority and TEP relating to Industrial
Development Revenue Bonds, 1982 Series A (Tucson Electric Power
Company Sundt Project). (Form S-4, Registration No. 33-52860 --
Exhibit 4(h)(3).)
*4(c)(4) -- First Supplemental Indenture of Trust, dated as of March 31,
1992, between the Pima County Authority and Morgan Guaranty
relating to Industrial Development Revenue Bonds, 1982 Series A
(Tucson Electric Power Company Sundt Project). (Form S-4,
Registration No. 33-52860 -- Exhibit 4(h)(4).)
*4(d)(1) -- Loan Agreement, dated as of December 1, 1982, between the Pima
County Authority and TEP relating to Floating Rate Monthly Demand
Industrial Development Revenue Bonds, 1982 Series A (Tucson
Electric Power Company Projects). (Form 10-K for the year ended
December 31, 1982, File No. 1-5924 -- Exhibit 4(k)(1).)
*4(d)(2) -- Indenture of Trust dated as of December 1, 1982, between the Pima
County Authority and Morgan Guaranty authorizing Floating Rate
Monthly Demand Industrial Development Revenue Bonds, 1982 Series
A (Tucson Electric Power Company Projects). (Form 10-K for the
year ended December 31, 1982, File No. 1-5924 -- Exhibit
4(k)(2).)
*4(d)(3) -- First Supplemental Loan Agreement, dated as of March 31, 1992,
between the Pima County Authority and TEP relating to Industrial
Development Revenue Bonds, 1982 Series A (Tucson Electric Power
Company Projects). (Form S-4, Registration No. 33-52860 --
Exhibit 4(i)(3).)
*4(d)(4) -- First Supplemental Indenture of Trust, dated as of March 31,
1992, between the Pima County Authority and Morgan Guaranty
relating to Industrial Development Revenue Bonds, 1982 Series A
K-158
(Tucson Electric Power Company Projects). (Form S-4, Registration
No. 33-52860 -- Exhibit 4(i)(4).)
*4(e)(1) -- Loan Agreement, dated as of December 1, 1983, between the Apache
County Authority and TEP relating to Floating Rate Monthly Demand
Industrial Development Revenue Bonds, 1983 Series A (Tucson
Electric Power Company Springerville Project). (Form 10-K for the
year ended December 31, 1983, File No. 1-5924 -- Exhibit
4(I)(1).)
*4(e)(2) -- Indenture of Trust, dated as of December 1, 1983, between the
Apache County Authority and Morgan Guaranty authorizing Floating
Rate Monthly Demand Industrial Development Revenue Bonds, 1983
Series A (Tucson Electric Power Company Springerville Project).
(Form 10-K for the year ended December 31, 1983, File no. 1-5924
-- Exhibit 4(I)(2).)
*4(e)(3) -- First Supplemental Loan Agreement, dated as of December 1, 1985,
between the Apache County Authority and TEP relating to Floating
Rate Monthly Demand Industrial Development Revenue Bonds, 1983
Series A (Tucson Electric Power Company Springerville Project).
(Form 10-K for the year ended December 31, 1987, File No. 1-5924
-- Exhibit 4(k)(3).)
*4(e)(4) -- First Supplemental Indenture, dated as of December 1, 1985,
between the Apache County Authority and Morgan Guaranty relating
to Floating Rate Monthly Demand Industrial Development Revenue
Bonds, 1983 Series A (Tucson Electric Power Company Springerville
Project). (Form 10-K for the year ended December 31, 1987, File
No. 1-5924 -- Exhibit 4(k)(4).)
*4(e)(5) -- Second Supplemental Loan Agreement, dated as of March 31, 1992,
between the Apache County Authority and TEP relating to
Industrial Development Revenue Bonds, 1983 Series A (Tucson
Electric Power Company Springerville Project). (Form S-4,
Registration No. 33-52860 -- Exhibit 4(k)(5).)
*4(e)(6) -- Second Supplemental Indenture of Trust, dated as of March 31,
1992, between the Apache County Authority and Morgan Guaranty
relating to Industrial Development Revenue Bonds, 1983 Series A
(Tucson Electric Power Company Springerville Project). (Form S-4,
Registration No. 33-52860 -- Exhibit 4(k)(6).)
*4(f)(1) -- Loan Agreement, dated as of December 1, 1983, between the Apache
County Authority and TEP relating to Variable Rate Demand
Industrial Development Revenue Bonds, 1983 Series B (Tucson
Electric Power Company Springerville Project). (Form 10-K for the
year ended December 31, 1983, File No. 1-5924 -- Exhibit
4(m)(1).)
*4(f)(2) -- Indenture of Trust dated as of December 1, 1983, between the
Apache County Authority and Morgan Guaranty authorizing Variable
Rate Demand Industrial Development Revenue Bonds. 1983 Series B
(Tucson Electric Power Company Springerville Project). (Form 10-K
for the year ended December 31, 1983, File No. 1-5924 -- Exhibit
4(m)(2).)
*4(f)(3) -- First Supplemental Loan Agreement, dated as of December 1, 1985,
between the Apache County Authority and TEP relating to Floating
Rate Monthly Demand Industrial Developmental Revenue Bonds, 1983
Series B (Tucson Electric Power Company Springerville Project).
(Form 10-K for the year ended December 31, 1987, File No. 1-5924
-- Exhibit 4(I)(3).)
*4(f)(4) -- First Supplemental Indenture, dated as of December 1, 1985,
between the Apache County Authority and Morgan Guaranty relating
to Floating Rate Monthly Demand Industrial Development Revenue
Bonds, 1983 Series B (Tucson Electric Power Company Springerville
Project). (Form 10-K for the year ended December 31, 1987, File
No. 1-5924 -- Exhibit 4(I)(4).)
*4(f)(5) -- Second Supplemental Loan Agreement, dated as of March 31, 1992,
between the Apache County Authority and TEP relating to
Industrial Development Revenue Bonds, 1983 Series B (Tucson
Electric Power Company Springerville Project). (Form S-4,
Registration No. 33-52860 -- Exhibit 4(I)(5).)
K-159
*4(f)(6) -- Second Supplemental Indenture of Trust, dated as of March 31,
1992, between the Apache County Authority and Morgan Guaranty
relating to Industrial Development Revenue Bonds, 1983 Series B
(Tucson Electric Power Company Springerville Project). (Form S-4,
Registration No. 33-52860 -- Exhibit 4(I)(6).)
*4(g)(1) -- Loan Agreement, dated as of December 1, 1983, between the Apache
County Authority and TEP relating to Variable Rate Demand
Industrial Development Revenue Bonds, 1983 Series C (Tucson
Electric Power Company Springerville Project). (Form 10-K for
year ended December 31, 1983, File No. 1-5924 -- Exhibit
4(n)(1).)
*4(g)(2) -- Indenture of Trust dated as of December 1, 1983, between the
Apache County Authority and Morgan Guaranty authorizing Variable
Rate Demand Industrial Development Revenue Bonds, 1983 Series C
(Tucson Electric Power Company Springerville Project). (Form 10-K
for the year ended December 31, 1983, File No. 1-5924 -- Exhibit
4(n)(2).)
*4(g)(3) -- First Supplemental Loan Agreement, dated as of December 1, 1985,
between the Apache County Authority and TEP relating to Floating
Rate Monthly Demand Industrial Development Revenue Bonds, 1983
Series C (Tucson Electric Power Company Springerville Project).
(Form 10-K for the year ended December 31, 1987, File No. 1-5924
-- Exhibit 4(m)(3).)
*4(g)(4) -- First Supplemental Indenture, dated as of December 1, 1985,
between the Apache County Authority and Morgan Guaranty relating
to Floating Rate Monthly Demand Industrial Development Revenue
Bonds, 1983 Series C (Tucson Electric Power Company Springerville
Project). (Form 10-K for the year ended December 31, 1987, File
No. 1-5924 -- Exhibit 4(m)(4).)
*4(g)(5) -- Second Supplemental Loan Agreement, dated as of March 31, 1992,
between the Apache County Authority and TEP relating to
Industrial Development Revenue Bonds, 1983 Series C (Tucson
Electric Power Company Springerville Project). (Form S-4,
Registration No. 33-52860 -- Exhibit 4(m)(5).)
*4(g)(6) -- Second Supplemental Indenture of Trust, dated as of March 31,
1992, between the Apache County Authority and Morgan Guaranty
relating to Industrial Development Revenue Bonds, 1983 Series C
(Tucson Electric Power Company Springerville Project). (Form S-4,
Registration No. 33-52860 -- Exhibit 4(m)(6).)
*4(h) -- Reimbursement Agreement, dated as of September 15, 1981, as
amended, between TEP and Manufacturers Hanover Trust Company.
(Form 10-K for the year ended December 31, 1984, File No. 1-5924
-- Exhibit 4(o)(4).)
*4(i)(1) -- Loan Agreement, dated as of December 1, 1985, between the Apache
County Authority and TEP relating to Variable Rate Demand
Industrial Development Revenue Bonds, 1985 Series A (Tucson
Electric Power Company Springerville Project). (Form 10-K for the
year ended December 31, 1985, File No. 1-5924 -- Exhibit
4(r)(1).)
*4(i)(2) -- Indenture of Trust dated as of December 1, 1985, between the
Apache County Authority and Morgan Guaranty authorizing Variable
Rate Demand Industrial Development Revenue Bonds, 1985 Series A
(Tucson Electric Power Company Springerville Project). (Form 10-K
for the year ended December 31, 1985, File No. 1-5924 -- Exhibit
4(r)(2).)
*4(i)(3) -- First Supplemental Loan Agreement, dated as of March 31, 1992,
between the Apache County Authority and TEP relating to
Industrial Development Revenue Bonds, 1985 Series A (Tucson
Electric Power Company Springerville Project). (Form S-4,
Registration No. 33-52860 -- Exhibit 4(o)(3).)
*4(i)(4) -- First Supplemental Indenture of Trust, dated as of March 31,
1992, between the Apache County Authority and Morgan Guaranty
relating to Industrial Development Revenue Bonds, 1985 Series A
(Tucson Electric Power Company Springerville Project). (Form S-4,
Registration No. 33-52860 -- Exhibit 4(o)(4).)
K-160
*4(j)(1) -- Indenture of Mortgage and Deed of Trust dated as of December 1,
1992, to Bank of Montreal Trust Company, Trustee. (Form S-1,
Registration No. 33-55732 -- Exhibit 4(r)(1).)
*4(j)(2) -- Supplemental Indenture No. 1 creating a series of bonds
designated Second Mortgage Bonds, Collateral Series A, dated as
of December 1, 1992. (Form S-1, Registration No. 33-55732 --
Exhibit 4(r)(2).)
*4(j)(3) -- Supplemental Indenture No. 2 creating a series of bonds
designated Second Mortgage Bonds, Collateral Series B, dated as
of December 1, 1997. (Form 10-K for year ended December 31, 1997,
File No. 1-5924 -- Exhibit 4(m)(3).)
*4(j)(4) -- Supplemental Indenture No. 3 creating a series of bonds
designated Second Mortgage Bonds, Collateral Series, dated as of
August 1, 1998. (Form 10-Q for the quarter ended June 30, 1998,
File No. 1-5924 -- Exhibit 4(c).)
*4(j)(5) -- Supplemental Indenture No. 4 creating a series of bonds
designated Second Mortgage Bonds, Collateral Series C, dated as
of November 1, 2002. (Form 8-K dated November 27, 2002, File Nos.
1-05924 and 1-13739 -- Exhibit 99.2.)
*4(j)(6) -- Supplemental Indenture No. 5 creating a series of bonds
designated Second Mortgage Bonds, Collateral Series D, dated as
of March 1, 2004. (Form 8-K dated March 31, 2004, File Nos.
1-05924 and 1-13739 -- Exhibit 10(b).)
*4(k)(1) -- Loan Agreement, dated as of April 1, 1997 between Coconino
County, Arizona Pollution Control Corporation and TEP relating to
Pollution Control Revenue Bonds, 1997 Series A (Tucson Electric
Power Company Navajo Project). (Form 10-Q for the quarter ended
March 31, 1997, File No. 1-5924 -- Exhibit 4(c).)
*4(k)(2) -- Indenture of Trust, dated as of April 1, 1997, between Coconino
County, Arizona Pollution Control Corporation and First Trust of
New York, National Association, authorizing Pollution Control
Revenue Bonds, 1997 Series A (Tucson Electric Power Company
Navajo Project). (Form 10-Q for the quarter ended March 31, 1997,
File No. 1-5924 -- Exhibit 4(d).)
*4(l)(1) -- Loan Agreement, dated as of April 1, 1997, between Coconino
County, Arizona Pollution Control Corporation and TEP relating to
Pollution Control Revenue Bonds, 1997 Series B (Tucson Electric
Power Company Navajo Project). (Form 10-Q for the quarter ended
March 31, 1997, File No. 1-5924 -- Exhibit 4(e).)
*4(l)(2) -- Indenture of Trust, dated as of April 1, 1997, between Coconino
County, Arizona Pollution Control Corporation and First Trust of
New York, National Association, authorizing Pollution Control
Revenue Bonds, 1997 Series B (Tucson Electric Power Company
Navajo Project). (Form 10-Q for the quarter ended March 31, 1997,
File No. 1-5924 -- Exhibit 4(f).)
*4(m)(1) -- Loan Agreement, dated as of September 15, 1997, between The
Industrial Development Authority of the County of Pima and TEP
relating to Industrial Development Revenue Bonds, 1997 Series A
(Tucson Electric Power Company Project). (Form 10-Q for the
quarter ended September 30, 1997, File No. 1-5924 -- Exhibit
4(a).)
*4(m)(2) -- Indenture of Trust, dated as of September 15, 1997, between The
Industrial Development Authority of the County of Pima and First
Trust of New York, National Association, authorizing Industrial
Development Revenue Bonds, 1997 Series A (Tucson Electric Power
Company Project). (Form 10-Q for the quarter ended September 30,
1997, File No. 1-5924 -- Exhibit 4(b).)
*4(n)(1) -- Loan Agreement, dated as of September 15, 1997, between The
Industrial Development Authority of the County of Pima and TEP
relating to Industrial Development Revenue Bonds, 1997 Series B
(Tucson Electric Power Company Project). (Form 10-Q for the
quarter ended September 30, 1997, File No. 1-5924 -- Exhibit
4(c).)
*4(n)(2) -- Indenture of Trust, dated as of September 15, 1997, between The
Industrial Development Authority of the County of Pima and First
Trust of New York, National Association, authorizing Industrial
K-161
Development Revenue Bonds, 1997 Series B (Tucson Electric Power
Company Project). (Form 10-Q for the quarter ended September 30,
1997, File No. 1-5924 -- Exhibit 4(d).)
*4(o)(1) -- Loan Agreement, dated as of September 15, 1997, between The
Industrial Development Authority of the County of Pima and TEP
relating to Industrial Development Revenue Bonds, 1997 Series C
(Tucson Electric Power Company Project). (Form 10-Q for the
quarter ended September 30, 1997, File No. 1-5924 -- Exhibit
4(e).)
*4(o)(2) -- Indenture of Trust, dated as of September 15, 1997, between The
Industrial Development Authority of the County of Pima and First
Trust of New York, National Association, authorizing Industrial
Development Revenue Bonds, 1997 Series C (Tucson Electric Power
Company Project). (Form 10-Q for the quarter ended September 30,
1997, File No. 1-5924 -- Exhibit 4(f).)
*4(p)(1) -- Loan Agreement, dated as of March 1, 1998, between The Industrial
Development Authority of the County of Apache and TEP relating
to Pollution Control Revenue Bonds, 1998 Series A (Tucson
Electric Power Company Project). (Form 10-Q for the quarter ended
March 31, 1998, File No. 1-5924 -- Exhibit 4(a).)
*4(p)(2) -- Indenture of Trust, dated as of March 1, 1998, between The
Industrial Development Authority of the County of Apache and
First Trust of New York, National Association, authorizing
Pollution Control Revenue Bonds, 1998 Series A (Tucson Electric
Power Company Project). (Form 10-Q for the quarter ended March
31, 1998, File No. 1-5924 -- Exhibit 4(b).)
*4(q)(1) -- Loan Agreement, dated as of March 1, 1998, between The Industrial
Development Authority of the County of Apache and TEP relating to
Pollution Control Revenue Bonds, 1998 Series B (Tucson Electric
Power Company Project). (Form 10-Q for the quarter ended March
31, 1998, File No. 1-5924 -- Exhibit 4(c).)
*4(q)(2) -- Indenture of Trust, dated as of March 1, 1998, between The
Industrial Development Authority of the County of Apache and
First Trust of New York, National Association, authorizing
Pollution Control Revenue Bonds, 1998 Series B (Tucson Electric
Power Company Project). (Form 10-Q for the quarter ended March
31, 1998, File No. 1-5924 -- Exhibit 4(d).)
*4(r)(1) -- Loan Agreement, dated as of March 1, 1998, between The Industrial
Development Authority of the County of Apache and TEP relating to
Industrial Development Revenue Bonds, 1998 Series C (Tucson
Electric Power Company Project). (Form 10-Q for the quarter ended
March 31, 1998, File No. 1-5924 -- Exhibit 4(e).)
*4(r)(2) -- Indenture of Trust, dated as of March 1, 1998, between The
Industrial Development Authority of the County of Apache and
First Trust of New York, National Association, authorizing
Industrial Development Revenue Bonds, 1998 Series C (Tucson
Electric Power Company Project). (Form 10-Q for the quarter ended
March 31, 1998, File No. 1-5924 -- Exhibit 4(f).)
*4(s)(1) -- Indenture of Trust, dated as of August 1, 1998, between TEP and
the Bank of Montreal Trust Company. (Form 10-Q for the quarter
ended June 30, 1998, File No. 1-5924 -- Exhibit 4(d).)
*4(t)(1) -- Rights Agreement dated as of March 5, 1999, between UniSource
Energy Corporation and The Bank of New York, as Rights Agent.
(Form 8-K dated March 5, 1999, File No. 1-13739 -- Exhibit 4.)
*4(u)(1) -- Credit Agreement dated as of March 25, 2004, among TEP, JP Morgan
Chase Bank, Credit Suisse First Boston and Lehman Brothers, Inc.,
as Co-Administrative Agents, The Bank of New York and Union Bank
of California, N.A., as Documentation Agents, and Credit Suisse
First Boston, as Paying Agent, the Lenders party Thereto, and the
Issuing Banks Party Thereto. (Form 8-K dated March 31, 2004, File
Nos. 1-5924 and 1-13739 -- Exhibit 10(a).)
K-162
*4(v)(1) -- Note Purchase and Guaranty Agreement dated August 11, 2003 among
UNS Gas, Inc., and UniSource Energy Services, Inc., and certain
institutional investors. (Form 8-K dated August 21, 2003, File
Nos. 1-5924 and 1-13739 -- Exhibit 99.2.)
*4(w)(1) -- Note Purchase and Guaranty Agreement date August 11, 2003 among
UNS Electric, Inc., and UniSource Energy Services, Inc., and
certain institutional investors. (Form 8-K dated August 21, 2003,
File Nos. 1-5924 and 1-13739 -- Exhibit 99.3.)
*4(x)(1) -- Indenture dated as of March 1, 2005, to The Bank of New York, as
Trustee. (Form 8-K dated March 3, 2005, File Nos. 1-5924 and
1-13739 -- Exhibit 4.1).
*4(y)(1) -- Registration Rights Agreement, dated as of March 1, 2005, between
UniSource Energy Corporation and Credit Suisse First Boston LLC,
as representative of the several initial purchasers (Form 8-K
dated March 3, 2005, File Nos. 1-5924 and 1-13739 -- Exhibit
4.2).
*10(a)(1) -- Lease Agreements, dated as of December 1, 1984, between Valencia
and United States Trust Company of New York, as Trustee, and
Thomas B. Zakrzewski, as Co-Trustee, as amended and supplemented.
(Form 10-K for the year ended December 31, 1984, File No. 1-5924
-- Exhibit 10(d)(1).)
*10(a)(2) -- Guaranty and Agreements, dated as of December 1, 1984, between
TEP and United States Trust Company of New York, as Trustee, and
Thomas B. Zakrzewski, as Co-Trustee. (Form 10-K for the year
ended December 31, 1984, File No. 1-5924 -- Exhibit 10(d)(2).)
*10(a)(3) -- General Indemnity Agreements, dated as of December 1, 1984,
between Valencia and TEP, as Indemnitors; General Foods Credit
Corporation, Harvey Hubbell Financial, Inc. and J.C. Penney
Company, Inc. as Owner Participants; United States Trust Company
of New York, as Owner Trustee; Teachers Insurance and Annuity
Association of America as Loan Participant; and Marine Midland
Bank, N.A., as Indenture Trustee. (Form 10-K for the year ended
December 31, 1984, File No. 1-5924 -- Exhibit 10(d)(3).)
*10(a)(4) -- Tax Indemnity Agreements, dated as of December 1, 1984, between
General Foods Credit Corporation, Harvey Hubbell Financial, Inc.
and J.C. Penney Company, Inc., each as Beneficiary under a
separate Trust Agreement dated December 1, 1984, with United
States Trust of New York as Owner Trustee, and Thomas B.
Zakrzewski as Co-Trustee, Lessor, and Valencia, Lessee, and TEP,
Indemnitors. (Form 10-K for the year ended December 31, 1984,
File No. 1-5924 -- Exhibit 10(d)(4).)
*10(a)(5) -- Amendment No. 1, dated December 31, 1984, to the Lease
Agreements, dated December 1, 1984, between Valencia and United
States Trust Company of New York, as Owner Trustee, and Thomas B.
Zakrzewski as Co-Trustee. (Form 10-K for the year ended December
31, 1986, File No. 1-5924 -- Exhibit 10(e)(5).)
*10(a)(6) -- Amendment No. 2, dated April 1, 1985, to the Lease Agreements,
dated December 1, 1984, between Valencia and United States Trust
Company of New York, as Owner Trustee, and Thomas B. Zakrzewski
as Co-Trustee. (Form 10-K for the year ended December 31, 1986,
File No. 1-5924 -- Exhibit 10(e)(6).)
*10(a)(7) -- Amendment No. 3 dated August 1, 1985, to the Lease Agreements,
dated December 1, 1984, between Valencia and United States Trust
Company of New York, as Owner Trustee, and Thomas Zakrzewski as
Co-Trustee. (Form 10-K for the year ended December 31, 1986, File
No. 1-5924 -- Exhibit 10(e)(7).)
*10(a)(8) -- Amendment No. 4, dated June 1, 1986, to the Lease Agreement,
dated December 1, 1984, between Valencia and United States Trust
Company of New York as Owner Trustee, and Thomas Zakrzewski as
Co-Trustee, under a Trust Agreement dated as of December 1, 1984,
with General Foods Credit Corporation as Owner Participant. (Form
10-K for the year ended December 31, 1986, File No. 1-5924 --
Exhibit 10(e)(8).)
*10(a)(9) -- Amendment No. 4, dated June 1, 1986, to the Lease Agreement,
dated December 1, 1984, between Valencia and United States Trust
Company of New York as Owner Trustee, and Thomas Zakrzewski as
K-163
Co-Trustee, under a Trust Agreement dated as of December 1, 1984,
with J.C. Penney Company, Inc. as Owner Participant. (Form 10-K
for the year ended December 31, 1986, File No. 1-5924 -- Exhibit
10(e)(9).)
*10(a)(10) -- Amendment No. 4, dated June 1, 1986, to the Lease Agreement,
dated December 1, 1984, between Valencia and United States Trust
Company of New York as Owner Trustee, and Thomas Zakrzewski as
Co-Trustee, under a Trust Agreement dated as of December 1, 1984,
with Harvey Hubbell Financial Inc. as Owner Participant. (Form
10-K for the year ended December 31, 1986, File No. 1-5924 --
Exhibit 10(e)(10).)
*10(a)(11) -- Lease Amendment No. 5 and Supplement No. 2, to the Lease
Agreement, dated July 1, 1986, between Valencia, United States
Trust Company of New York as Owner Trustee, and Thomas Zakrzewski
as Co-Trustee and J.C. Penney as Owner Participant. (Form 10-K
for the year ended December 31, 1986, File No. 1-5924 -- Exhibit
10(e)(11).)
*10(a)(12) -- Lease Amendment No. 5, to the Lease Agreement, dated June 1,
1987, between Valencia, United States Trust Company of New York
as Owner Trustee, and Thomas Zakrzewski as Co-Trustee and General
Foods Credit Corporation as Owner Participant. (Form 10-K for the
year ended December 31, 1988, File No. 1-5924 -- Exhibit
10(f)(12).)
*10(a)(13) -- Lease Amendment No. 5, to the Lease Agreement, dated June 1,
1987, between Valencia, United States Trust Company of New York
as Owner Trustee, and Thomas Zakrzewski as Co-Trustee and Harvey
Hubbell Financial Inc. as Owner Participant. (Form 10-K for the
year ended December 31, 1988, File No. 1-5924 -- Exhibit
10(f)(13).)
*10(a)(14) -- Lease Amendment No. 6, to the Lease Agreement, dated June 1,
1987, between Valencia, United States Trust Company of New York
as Owner Trustee, and Thomas Zakrzewski as Co-Trustee and J.C.
Penney Company, Inc. as Owner Participant. (Form 10-K for the
year ended December 31, 1988, File No. 1-5924 -- Exhibit
10(f)(14).)
*10(a)(15) -- Lease Supplement No. 1, dated December 31, 1984, to Lease
Agreements, dated December 1, 1984, between Valencia, as Lessee
and United States Trust Company of New York and Thomas B.
Zakrzewski, as Owner Trustee and Co-Trustee, respectively
(document filed relates to General Foods Credit Corporation;
documents relating to Harvey Hubbell Financial, Inc. and JC
Penney Company, Inc. are not filed but are substantially
similar). (Form S-4 Registration No. 33-52860 -- Exhibit
10(f)(15).)
*10(a)(16) -- Amendment No. 1, dated June 1, 1986, to the General Indemnity
Agreement, dated as of December 1, 1984, between Valencia and
TEP, as Indemnitors, General Foods Credit Corporation, as Owner
Participant, United States Trust Company of New York, as Owner
Trustee, Teachers Insurance and Annuity Association of America,
as Loan Participant, and Marine Midland Bank, N.A., as Indenture
Trustee. (Form 10-K for the year ended December 31, 1986, File
No. 1-5924 -- Exhibit 10(e)(12).)
*10(a)(17) -- Amendment No. 1, dated June 1, 1986, to the General Indemnity
Agreement, dated as of December 1, 1984, between Valencia and
TEP, as Indemnitors, J.C. Penney Company, Inc., as Owner
Participant, United States Trust Company of New York, as Owner
Trustee, Teachers Insurance and Annuity Association of America,
as Loan Participant, and Marine Midland Bank, N.A., as Indenture
Trustee. (Form 10-K for the year ended December 31, 1986, File
No. 1-5924 -- Exhibit 10(e)(13).)
*10(a)(18) -- Amendment No. 1, dated June 1, 1986, to the General Indemnity
Agreement, dated as of December 1, 1984, between Valencia and
TEP, as Indemnitors, Harvey Hubbell Financial, Inc., as Owner
Participant, United States Trust Company of New York, as Owner
Trustee, Teachers Insurance and Annuity Association of America,
as Loan Participant, and Marine Midland Bank, N.A., as Indenture
Trustee. (Form 10-K for the year ended December 31, 1986, File
No. 1-5924 -- Exhibit 10(e)(14).)
*10(a)(19) -- Amendment No. 2, dated as of July 1, 1986, to the General
Indemnity Agreement, dated as of December 1, 1984, between
Valencia and TEP, as Indemnitors, J.C. Penney Company, Inc., as
K-164
Owner Participant, United States Trust Company of New York, as
Owner Trustee, Teachers Insurance and Annuity Association of
America, as Loan Participant, and Marine Midland Bank, N.A., as
Indenture Trustee. (Form S-4, Registration No. 33-52860 --
Exhibit 10(f)(19).)
*10(a)(20) -- Amendment No. 2, dated as of June 1, 1987, to the General
Indemnity Agreement, dated as of December 1, 1984, between
Valencia and TEP, as Indemnitors, General Foods Credit
Corporation, as Owner Participant, United States Trust Company of
New York, as Owner Trustee, Teachers Insurance and Annuity
Association of America, as Loan Participant, and Marine Midland
Bank, N.A., as Indenture Trustee. (Form S-4, Registration No.
33-52860 --Exhibit 10(f)(20).)
*10(a)(21) -- Amendment No. 2, dated as of June 1, 1987, to the General
Indemnity Agreement, dated as of December 1, 1984, between
Valencia and TEP, as Indemnitors, Harvey Hubbell Financial, Inc.,
as Owner Participant, United States Trust Company of New York, as
Owner Trustee, Teachers Insurance and Annuity Association of
America, as Loan Participant, and Marine Midland Bank, N.A., as
Indenture Trustee. (Form S-4, Registration No. 33-52860 --
Exhibit 10(f)(21).)
*10(a)(22) -- Amendment No. 3, dated as of June 1, 1987, to the General
Indemnity Agreement, dated as of December 1, 1984, between
Valencia and TEP, as Indemnitors, J.C. Penney Company, Inc., as
Owner Participant, United States Trust Company of New York, as
Owner Trustee, Teachers Insurance and Annuity Association of
America, as Loan Participant, and Marine Midland Bank, N.A., as
Indenture Trustee. (Form S-4, Registration No. 33-52860 --
Exhibit 10(f)(22).)
*10(a)(23) -- Supplemental Tax Indemnity Agreement, dated July 1, 1986, between
J.C. Penney Company, Inc., as Owner Participant, and Valencia and
TEP, as Indemnitors. (Form 10-K for the year ended December 31,
1986, File No. 1-5924 -- Exhibit 10(e)(15).)
*10(a)(24) -- Supplemental General Indemnity Agreement, dated as of July 1,
1986, among Valencia and TEP, as Indemnitors, J.C. Penney
Company, Inc., as Owner Participant, United States Trust Company
of New York, as Owner Trustee, Teachers Insurance and Annuity
Association of America, as Loan Participant, and Marine Midland
Bank, N.A., as Indenture Trustee. (Form 10-K for the year ended
December 31, 1986, File No. 1-5924 -- Exhibit 10(e)(16).)
*10(a)(25) -- Amendment No. 1, dated as of June 1, 1987, to the Supplemental
General Indemnity Agreement, dated as of July 1, 1986, among
Valencia and TEP, as Indemnitors, J.C. Penney Company, Inc., as
Owner Participant, United States Trust Company of New York, as
Owner Trustee, Teachers Insurance and Annuity Association of
America, as Loan Participant, and Marine Midland Bank, N.A., as
Indenture Trustee. (Form S-4, Registration No. 33-52860 --
Exhibit 10(f)(25).)
*10(a)(26) -- Valencia Agreement, dated as of June 30, 1992, among TEP, as
Guarantor, Valencia, as Lessee, Teachers Insurance and Annuity
Association of America, as Loan Participant, Marine Midland Bank,
N.A., as Indenture Trustee, United States Trust Company of New
York, as Owner Trustee, and Thomas B. Zakrzewski, as Co-Trustee,
and the Owner Participants named therein relating to the
Restructuring of Valencia's lease of the coal-handling facilities
at the Springerville Generating Station. (Form S-4, Registration
No. 33-52860 -- Exhibit 10(f)(26).)
*10(a)(27) -- Amendment, dated as of December 15, 1992, to the Lease
Agreements, dated December 1, 1984, between Valencia, as Lessee,
and United States Trust Company of New York, as Owner Trustee,
and Thomas B. Zakrzewski, as Co-Trustee. (Form S-1, Registration
No. 33-55732 -- Exhibit 10(f)(27).)
*10(b)(1) -- Lease Agreements, dated as of December 1, 1985, between TEP and
San Carlos Resources Inc. (San Carlos) (a wholly-owned subsidiary
of the Registrant) jointly and severally, as Lessee, and
Wilmington Trust Company, as Trustee, as amended and
supplemented. (Form 10-K for the year ended December 31, 1985,
File No. 1-5924 -- Exhibit 10(f)(1).)
K-165
*10(b)(2) -- Tax Indemnity Agreements, dated as of December 1, 1985, between
Philip Morris Credit Corporation, IBM Credit Financing
Corporation and Emerson Finance Co., each as beneficiary under a
separate trust agreement, dated as of December 1, 1985, with
Wilmington Trust Company, as Owner Trustee, and William J. Wade,
as Co-Trustee, and TEP and San Carlos, as Lessee. (Form 10-K for
the year ended December 31, 1985, File No. 1-5924 -- Exhibit
10(f)(2).)
*10(b)(3) -- Participation Agreement, dated as of December 1, 1985, among TEP
and San Carlos as Lessee, Philip Morris Credit Corporation, IBM
Credit Financing Corporation, and Emerson Finance Co. as Owner
Participants, Wilmington Trust Company as Owner Trustee, The
Sumitomo Bank, Limited, New York Branch, as Loan Participant, and
Bankers Trust Company, as Indenture Trustee. (Form 10-K for the
year ended December 31, 1985, File No. 1-5924 -- Exhibit
10(f)(3).)
*10(b)(4) -- Restructuring Commitment Agreement, dated as of June 30, 1992,
among TEP and San Carlos, jointly and severally, as Lessee,
Philip Morris Credit Corporation, IBM Credit Financing
Corporation and Emerson Capital Funding, William J. Wade, as
Owner Trustee and Co-Trustee, respectively, The Sumitomo Bank,
Limited, New York Branch, as Loan Participant and United States
Trust Company of New York, as Indenture Trustee. (Form S-4,
Registration No. 33-52860 -- Exhibit 10(g)(4).)
*10(b)(5) -- Lease Supplement No.1, dated December 31, 1985, to Lease
Agreements, dated as of December 1, 1985, between TEP and San
Carlos, jointly and severally, as Lessee Trustee and Co-Trustee,
respectively (document filed relates to Philip Morris Credit
Corporation; documents relating to IBM Credit Financing
Corporation and Emerson Financing Co. are not filed but are
substantially similar). (Form S-4, Registration No. 33-52860 --
Exhibit 10(g)(5).)
*10(b)(6) -- Amendment No. 1, dated as of December 15, 1992, to Lease
Agreements, dated as of December 1, 1985, between TEP and San
Carlos, jointly and severally, as Lessee, and Wilmington Trust
Company and William J. Wade, as Owner Trustee and Co-Trustee,
respectively, as Lessor. (Form S-1, Registration No. 33-55732 --
Exhibit 10(g)(6).)
*10(b)(7) -- Amendment No. 1, dated as of December 15, 1992, to Tax Indemnity
Agreements, dated as of December 1, 1985, between Philip Morris
Credit Corporation, IBM Credit Financing Corporation and Emerson
Capital Funding Corp., as Owner Participants and TEP and San
Carlos, jointly and severally, as Lessee. (Form S-1, Registration
No. 33-55732 -- Exhibit 10(g)(7).)
*10(b)(8) -- Amendment No. 2, dated as of December 1, 1999, to Lease
Agreement, dated as of December 1, 1985, between TEP and San
Carlos, jointly and severally, as Lessee, and Wilmington Trust
Company and William J. Wade, as Owner Trustee and Co-Trustee,
respectively, under a Trust Agreement with Philip Morris Capital
Corporation as Owner Participant. (Form 10-K for the year ended
December 31, 1999, File No. 1-5924 -- Exhibit 10(b)(8).)
*10(b)(9) -- Amendment No. 2, dated as of December 1, 1999, to Lease
Agreement, dated as of December 1, 1985, between TEP and San
Carlos, jointly and severally, as Lessee, and Wilmington Trust
Company and William J. Wade, as Owner Trustee and Co-Trustee,
respectively, under a Trust Agreement with IBM Credit Financing
Corporation as Owner Participant. (Form 10-K for the year ended
December 31, 1999, File No. 1-5924 -- Exhibit 10(b)(9).)
*10(b)(10) -- Amendment No. 2, dated as of December 1, 1999, to Lease
Agreement, dated as of December 1, 1985, between TEP and San
Carlos, jointly and severally, as Lessee, and Wilmington Trust
Company and William J. Wade, as Owner Trustee and Co-Trustee,
respectively, under a Trust Agreement with Emerson Finance Co. as
Owner Participant. (Form 10-K for the year ended December 31,
1999, File No. 1-5924 -- Exhibit 10(b)(10).)
*10(b)(11) -- Amendment No. 2, dated as of December 1, 1999, to Tax Indemnity
Agreement, dated as of December 1, 1985, between TEP and San
Carlos, jointly and severally, as Lessee, and Philip Morris
Capital Corporation as Owner Participant, beneficiary under a
Trust Agreement dated as of December 1, 1985, with Wilmington
K-166
Trust Company and William J. Wade, as Owner Trustee and
Co-Trustee, respectively, together as Lessor. (Form 10-K for the
year ended December 31, 1999, File No. 1-5924 -- Exhibit
10(b)(11).)
*10(b)(12) -- Amendment No. 2, dated as of December 1, 1999, to Tax Indemnity
Agreement, dated as of December 1, 1985, between TEP and San
Carlos, jointly and severally, as Lessee, and IBM Credit
Financing Corporation as Owner Participant, beneficiary under a
Trust Agreement dated as of December 1, 1985, with Wilmington
Trust Company and William J. Wade, as Owner Trustee and
Co-Trustee, respectively, together as Lessor. (Form 10-K for the
year ended December 31, 1999, File No. 1-5924 -- Exhibit
10(b)(12).)
*10(b)(13) -- Amendment No. 2, dated as of December 1, 1999, to Tax Indemnity
Agreement, dated as of December 1, 1985, between TEP and San
Carlos, jointly and severally, as Lessee, and Emerson Finance Co.
as Owner Participant, beneficiary under a Trust Agreement dated
as of December 1, 1985, with Wilmington Trust Company and William
J. Wade, as Owner Trustee and Co-Trustee, respectively, together
as Lessor. (Form 10-K for the year ended December 31, 1999, File
No. 1-5924 -- Exhibit 10(b)(13).)
*10(b)(14) -- Amendment No. 3 dated as of June 1, 2003, to Lease Agreements,
dated as of December 1, 1985, between TEP and San Carlos, jointly
and severally, as Lessee, and Wilmington Trust Company and
William J. Wade, as Owner Trustee and Co-Trustee, respectively,
under a Trust Agreement with Philip Morris Capital Corporation as
Owner Participant.
*10(b)(15) -- Amendment No. 3 dated as of June 1, 2003, to Lease Agreements,
dated as of December 1, 1985, between TEP and San Carlos, jointly
and severally, as Lessee, and Wilmington Trust Company and
William J. Wade, as Owner Trustee and Co-Trustee, respectively,
under a Trust Agreement with IBM Credit, LLC as Owner
Participant.
*10(b)(16) -- Amendment No. 3 dated as of June 1, 2003, to Lease Agreements,
dated as of December 1, 1985, between TEP and San Carlos, jointly
and severally, as Lessee, and Wilmington Trust Company and
William J. Wade, as Owner Trustee and Co-Trustee, respectively,
under a Trust Agreement with Emerson Finance Co. as Owner
Participant.
*10(b)(17) -- Amendment No. 3 dated as of June 1, 2003, to Tax Indemnity
Agreement, dated as of December 1, 1985, between TEP and San
Carlos, jointly and severally, as Lessee, and Philip Morris
Capital Corporation as Owner Participant, beneficiary under a
Trust Agreement dated as of December 1, 1985, with Wilmington
Trust Company and William J. Wade, as Owner Trustee and
Co-Trustee, respectively, together as Lessor.
*10(b)(18) -- Amendment No. 3 dated as of June 1, 2003, to Tax Indemnity
Agreement, dated as of December 1, 1985, between TEP and San
Carlos, jointly and severally, as Lessee, and IBM Credit, LLC as
Owner Participant, beneficiary under a Trust Agreement dated as
of December 1, 1985, with Wilmington Trust Company and William J.
Wade, as Owner Trustee and Co-Trustee, respectively, together as
Lessor.
*10(b)(19) -- Amendment No. 3 dated as of June 1, 2003, to Tax Indemnity
Agreement, dated as of December 1, 1985, between TEP and San
Carlos, jointly and severally, as Lessee, and Emerson Finance Co.
as Owner Participant, beneficiary under a Trust Agreement dated
as of December 1, 1985, with Wilmington Trust Company and William
J. Wade, as Owner Trustee and Co-Trustee, respectively, together
as Lessor.
*10(c)(1) -- Amended and Restated Participation Agreement, dated as of
November 15, 1987, among TEP, as Lessee, Ford Motor Credit
Company, as Owner Participant, Financial Security Assurance Inc.,
as Surety, Wilmington Trust Company and William J. Wade in their
respective individual capacities as provided therein, but
otherwise solely as Owner Trustee and Co-Trustee under the Trust
Agreement, and Morgan Guaranty, in its individual capacity as
provided therein, but Secured Party. (Form 10-K for the year
ended December 31, 1987, File No. 1-5924 -- Exhibit 10(j)(1).)
*10(c)(2) -- Lease Agreement, dated as of January 14, 1988, between Wilmington
Trust Company and William J. Wade, as Owner Trust Agreement
described therein, dated as of November 15, 1987, between such
K-167
parties and Ford Motor Credit Company, as Lessor, and TEP, as
Lessee. (Form 10-K for the year ended December 31, 1987, File
No.1-5924 -- Exhibit 10(j)(2).)
*10(c)(3) -- Tax Indemnity Agreement, dated as of January 14, 1988, between
TEP, as Lessee, and Ford Motor Credit Company, as Owner
Participant, beneficiary under a Trust Agreement, dated as of
November 15, 1987, with Wilmington Trust Company and William J.
Wade, Owner Trustee and Co-Trustee, respectively, together as
Lessor. (Form 10-K for the year ended December 31, 1987, File No.
1-5924 -- Exhibit 10(j)(3).)
*10(c)(4) -- Loan Agreement, dated as of January 14, 1988, between the Pima
County Authority and Wilmington Trust Company and William J. Wade
in their respective individual capacities as expressly stated,
but otherwise solely as Owner Trustee and Co-Trustee,
respectively, under and pursuant to a Trust Agreement, dated as
of November 15, 1987, with Ford Motor Credit Company as Trustor
and Debtor relating to Industrial Development Lease Obligation
Refunding Revenue Bonds, 1988 Series A (TEP's Sundt Project).
(Form 10-K for the year ended December 31, 1987, File No. 1-5924
-- Exhibit 10(j)(4).)
*10(c)(5) -- Indenture of Trust, dated as of January 14, 1988, between the
Pima County Authority and Morgan Guaranty authorizing Industrial
Development Lease Obligation Refunding Revenue Bonds, 1988 Series
A (Tucson Electric Power Company Sundt Project). (Form 10-K for
the year ended December 31, 1987, File No. 1-5924 -- Exhibit
10(j)(5).)
*10(c)(6) -- Lease Amendment No. 1, dated as of May 1, 1989, between TEP,
Wilmington Trust Company and William J. Wade as Owner Trustee and
Co-Trustee, respectively under a Trust Agreement dated as of
November 15, 1987 with Ford Motor Credit Company. (Form 10-K for
the year ended December 31, 1990, File No. 1-5924 -- Exhibit
10(i)(6).)
*10(c)(7) -- Lease Supplement, dated as of January 1, 1991, between TEP,
Wilmington Trust Company and William J. Wade as Owner Trustee and
Co-Trustee, respectively, under a Trust Agreement dated as of
November 15, 1987, with Ford. (Form 10-K for the year ended
December 31, 1991, File No. 1-5924 -- Exhibit 10(i)(8).)
*10(c)(8) -- Lease Supplement, dated as of March 1, 1991, between TEP,
Wilmington Trust Company and William J. Wade as Owner Trustee and
Co-Trustee, respectively, under a Trust Agreement dated as of
November 15, 1987, with Ford. (Form 10-K for the year ended
December 31, 1991, File No. 1-5924 -- Exhibit 10(i)(9).)
*10(c)(9) -- Lease Supplement No. 4, dated as of December 1, 1991, between
TEP, Wilmington Trust Company and William J. Wade as Owner
Trustee and Co-Trustee, respectively, under a Trust Agreement
dated as of November 15, 1987, with Ford. (Form 10-K for the year
ended December 31, 1991, File No. 1-5924 -- Exhibit 10(i)(10).)
*10(c)(10) -- Supplemental Indenture No. 1, dated as of December 1, 1991,
between the Pima County Authority and Morgan Guaranty relating to
Industrial Lease Development Obligation Revenue Project. (Form
10-K for the year ended December 31, 1991, File No. 1-5924 --
Exhibit 10(l)(11).)
*10(c)(11) -- Restructuring Commitment Agreement, dated as of June 30, 1992,
among TEP, as Lessee, Ford Motor Credit Company, as Owner
Participant, Wilmington Trust Company and William J. Wade, as
Owner Trustee and Co-Trustee, respectively, and Morgan Guaranty,
as Indenture Trustee and Refunding Trustee, relating to the
restructuring of the Registrant's lease of Unit 4 at the Sundt
Generating Station. (Form S-4, Registration No. 33-52860 --
Exhibit 10(i)(12).)
*10(c)(12) -- Amendment No. 1, dated as of December 15, 1992, to Amended and
Restated Participation Agreement, dated as of November 15, 1987,
among TEP, as Lessee, Ford Motor Credit Company, as Owner
Participant, Wilmington Trust Company and William J. Wade, as
Owner Trustee and Co-Trustee, respectively, Financial Security
Assurance Inc., as Surety, and Morgan Guaranty, as Indenture
Trustee. (Form S-1, Registration No. 33-55732 -- Exhibit
10(h)(12).)
K-168
*10(c)(13) -- Amended and Restated Lease, dated as of December 15, 1992,
between TEP as Lessee and Wilmington Trust Company and William J.
Wade, as Owner Trustee and Co-Trustee, respectively, as Lessor.
(Form S-1, Registration No. 33-55732 -- Exhibit 10(h)(13).)
*10(c)(14) -- Amended and Restated Tax Indemnity Agreement, dated as of
December 15, 1992, between TEP as Lessee and Ford Motor Credit
Company, as Owner Participant. (Form S-1, Registration No.
33-55732 -- Exhibit 10(h)(14).)
*10(d) -- Power Sale Agreement for the years 1990 to 2011, dated as of
March 10, 1988, between TEP and Salt River Project Agricultural
Improvement and Power District. (Form 10-K for the year ended
December 31, 1987, File No. 1-5924 -- Exhibit 10(k).)
*10(e) -- Participation Agreement, dated as of June 30, 1992, among TEP, as
Lessee, various parties thereto, as Owner, Wilmington Trust
Company and William J. Wade, as Owner Trustee and Co-Trustee,
respectively, and LaSalle National Bank, as Indenture Trustee
relating to TEP's lease of Springerville Unit 1. (Form S-1,
Registration No. 33-55732 -- Exhibit 10(u).)
*10(f) -- Lease Agreement, dated as of December 15, 1992, between TEP, as
Lessee and Wilmington Trust Company and William J. Wade, as Owner
Trustee and Co-Trustee, respectively, as Lessor. (Form S-1,
Registration No. 33-55732 -- Exhibit 10(v).)
*10(g) -- Tax Indemnity Agreements, dated as of December 15, 1992, between
the various Owner Participants parties thereto and TEP, as
Lessee. (Form S-1, Registration No. 33-55732 -- Exhibit 10(w).)
*10(h) -- Restructuring Agreement, dated as of December 1, 1992, between
TEP and Century Power Corporation. (Form S-1, Registration No.
33-55732 -- Exhibit 10(x).)
*10(i) -- Voting Agreement, dated as of December 15, 1992, between TEP and
Chrysler Capital Corporation (documents relating to CILCORP Lease
Management, Inc., MWR Capital Inc., US West Financial Services,
Inc. and Philip Morris Capital Corporation are not filed but are
substantially similar). (Form S-1, Registration No. 33-55732 --
Exhibit 10(y).)
*10(j)(1) -- Wholesale Power Supply Agreement between TEP and Navajo Tribal
Utility Authority dated January 5, 1993. (Form 10-K for the year
ended December 31, 1992, File No. 1-5924 -- Exhibit 10(t).)
*10(j)(2) -- Amended and Restated Wholesale Power Supply Agreement between TEP
and Navajo Tribal Utility Authority, dated June 25, 1997. (Form
10-Q for the quarter ended June 30, 1997, File No. 1-5924 --
Exhibit 10.)
+*10(k) -- 1994 Omnibus Stock and Incentive Plan of UniSource Energy. (Form
S-8 dated January 6, 1998, File No. 333-43767.)
+*10(l) -- Management and Directors Deferred Compensation Plan of UniSource
Energy. (Form S-8 dated January 6, 1998, File No. 333-43769.)
+*10(m) -- TEP Supplemental Retirement Account for Classified Employees.
(Form S-8 dated May 21, 1998, File No. 333-53309.)
+*10(n) -- TEP Triple Investment Plan for Salaried Employees. (Form S-8
dated May 21, 1998, File No. 333-53333.)
+*10(o) -- UniSource Energy Management and Directors Deferred Compensation
Plan. (Form S-8 dated May 21, 1998, File No. 333-53337.)
+10(p) -- Officer Change in Control Agreement between TEP and Karen G.
Kissinger, dated as of December 4, 1998 (including a schedule of
other officers who are covered by substantially identical
agreements.)
K-169
+10(q) -- Notice of Termination of Change in Control Agreement from TEP
to Karen G. Kissinger, dated as of March 3, 2005 (including a
schedule of other officers who received substantially identical
notices.)
+*10(r) -- Amended and Restated UniSource Energy 1994 Outside Director Stock
Option Plan of UniSource Energy. (Form S-8 dated September 9,
2002, File No. 333-99317.)
*10(s)(1) -- Asset Purchase Agreement dated as of October 29, 2002, by and
between UniSource Energy and Citizens Communications Company
relating to the Purchase of Citizens' Electric Utility Business
in the State of Arizona. (Form 8-K dated October 31, 2002. File
No. 1-13739 -- Exhibit 99-1.)
*10(s)(2) -- Asset Purchase Agreement dated as of October 29, 2002, by and
between UniSource Energy and Citizens Communications Company
relating to the Purchase of Citizens' Gas Utility Business in the
State of Arizona. (Form 8-K dated October 31, 2002. File No.
1-13739 -- Exhibit 99-2.)
12(a) -- Computation of Ratio of Earnings to Fixed Charges - TEP.
12(b) -- Computation of Ratio of Earnings to Fixed Charges - UniSource
Energy.
21 -- Subsidiaries of the Registrants.
23(a) -- Consent of Independent Registered Public Accounting Firm -
UniSource Energy
23(b) -- Consent of Independent Registered Public Accounting Firm - Tucson
Electric Power Company
24(a) -- Power of Attorney - UniSource Energy.
24(b) -- Power of Attorney - TEP.
31(a) -- Certification Pursuant to Section 302 of the Sarbanes-Oxley Act -
UniSource Energy, by James S. Pignatelli.
31(b) -- Certification Pursuant to Section 302 of the Sarbanes-Oxley Act -
UniSource Energy by Kevin P. Larson.
31(c) -- Certification Pursuant to Section 302 of the Sarbanes-Oxley Act -
TEP, by James S. Pignatelli.
31(d) -- Certification Pursuant to Section 302 of the Sarbanes-Oxley Act -
TEP, by Kevin P. Larson.
**32 -- Statements of Corporate Officers (pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002).
(*) Previously filed as indicated and incorporated herein by reference.
(+) Management contracts or compensatory plans or arrangements required to be
filed as exhibits to this Form 10-K by item 601(b)(10)(iii) of Regulation
S-K.
** Pursuant to Item 601(b)(32)(ii) of Regulation S-K, this certificate is not
being filed for purposes of Section 18 of the Securities Act of 1934.
K-170
APPENDIX B
--------------------------------------------------------------------------------
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For The Quarterly Period Ended March 31, 2005
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from __________ to __________.
Commission Registrant; State of Incorporation; IRS Employer
File Number Address; and Telephone Number Identification Number
----------- ----------------------------- ---------------------
1-13739 UNISOURCE ENERGY CORPORATION 86-0786732
(An Arizona Corporation)
One South Church Avenue, Suite 100
Tucson, AZ 85701
(520) 571-4000
1-5924 TUCSON ELECTRIC POWER COMPANY 86-0062700
(An Arizona Corporation)
One South Church Avenue, Suite 100
Tucson, AZ 85701
(520) 571-4000
Indicate by check mark whether each registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes X No
----- -----
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
UniSource Energy Corporation Yes X No
----- -----
Tucson Electric Power Company Yes No X
----- -----
At May 4, 2005, 34,556,088 shares of UniSource Energy Corporation Common
Stock, no par value (the only class of Common Stock), were outstanding.
At May 4, 2005, 32,139,555 shares of Tucson Electric Power Company's common
stock, no par value, were outstanding, of which 32,139,434 shares were held by
UniSource Energy Corporation.
--------------------------------------------------------------------------------
This combined Form 10-Q is separately filed by UniSource Energy Corporation and
Tucson Electric Power Company. Information contained in this document relating
to Tucson Electric Power Company is filed by UniSource Energy Corporation and
separately by Tucson Electric Power Company on its own behalf. Tucson Electric
Power Company makes no representation as to information relating to UniSource
Energy Corporation or its subsidiaries, except as it may relate to Tucson
Electric Power Company.
TABLE OF CONTENTS
Definitions v
-- PART I --
Reports of Independent Registered Public Accounting Firm 1
Item 1. - Financial Statements 3
UniSource Energy Corporation
Comparative Condensed Consolidated Statements of Income (Loss) 3
Comparative Condensed Consolidated Statements of Cash Flows 4
Comparative Condensed Consolidated Balance Sheets 5
Condensed Consolidated Statement of Changes in Stockholders' Equity 6
Tucson Electric Power Company
Comparative Condensed Consolidated Statements of Income (Loss) 7
Comparative Condensed Consolidated Statements of Cash Flows 8
Comparative Condensed Consolidated Balance Sheets 9
Condensed Consolidated Statement of Changes in Stockholders' Equity 10
Notes to Condensed Consolidated Financial Statements 11
Note 1. Nature of Operations, Basis of Accounting Presentation and
Equity-Based Compensation 11
Note 2. Regulatory Matters 13
Note 3. Debt and Credit Facilities 14
Note 4. Business Segments 17
Note 5. Accounting for Derivative Instruments and Trading Activities 18
Note 6. Commitments and Contingencies 20
Note 7. TEP Wholesale Accounts Receivable and Allowances 22
Note 8. UniSource Energy Earnings Per Share (EPS) 22
Note 9. Employee Benefit Plans 23
Note 10. Share-Based Compensation Plans 24
Note 11. Income and Other Taxes 25
Note 12. New Accounting Pronouncements 26
Note 13. Supplemental Cash Flow Information 27
Note 14. Review by Independent Accountants 28
Item 2. - Management's Discussion and Analysis of Financial Condition
and Results of Operations 29
UniSource Energy Consolidated 29
Results of Operations 30
Contribution by Business Segment 30
Liquidity and Capital Resources 31
Tucson Electric Power Company 35
Results of Operations 35
Factors Affecting Results of Operations 37
Liquidity and Capital Resources 40
UNS Gas 44
Results of Operations 44
Factors Affecting Results of Operations 45
Liquidity and Capital Resources 45
UNS Electric 47
Results of Operations 47
Factors Affecting Results of Operations 48
Liquidity and Capital Resources 48
Global Solar Energy, Inc. 50
Results of Operations 50
Other 50
Results of Operations 50
Critical Accounting Estimates 51
New Accounting Pronouncements 57
Safe Harbor for Forward-Looking Statements 58
ii
Item 3. - Quantitative and Qualitative Disclosures about Market Risk 59
Item 4. - Controls and Procedures 62
PART II - OTHER INFORMATION
Item 1. - Legal Proceedings 62
Item 5. - Other Information 63
TEP Credit Agreement 63
Non-GAAP Measures 63
SEC Reports Available on UniSource Energy's Website 66
Item 6. Exhibits 67
Signatures 68
Exhibit Index 69
iii
DEFINITIONS
The abbreviations and acronyms used in the 2005 First Quarter 10-Q are defined
below:
--------------------------------------------------------------------------------
ACC........................... Arizona Corporation Commission.
ACC Holding Company Order..... The order approved by the ACC in November
1997 allowing TEP to form a holding company.
AHMSA......................... Altos Hornos de Mexico, S.A. de C.V. AHMSA
owns 50% of Sabinas.
AMT........................... Alternative Minimum Tax.
APS........................... Arizona Public Service Company.
Btu........................... British thermal unit(s).
Capacity...................... The ability to produce power; the most power
a unit can produce or the maximum that can
be taken under a contract; measured in MWs.
CISO.......................... California Independent System Operator.
Citizens...................... Citizens Communications Company.
Citizens Settlement Agreement. An agreement with the ACC Staff dated
April 1, 2003, addressing rate case and
financing issues in the acquisition by
UniSource Energy of Citizens' Arizona gas and
electric assets.
Common Stock.................. UniSource Energy's common stock, without
par value.
Company or UniSource Energy... UniSource Energy Corporation.
Convertible Senior Notes...... UniSource Energy's 4.50% Convertible Senior
Notes due March 1, 2035.
Emissions Allowance(s)........ An allowance issued by the EPA which permits
emission of one ton of sulfur dioxide or one
ton of nitrogen oxide. These allowances
can be bought and sold.
Energy........................ The amount of power produced over a
given period of time; measured in MWh.
EPA........................... The Environmental Protection Agency.
ESP........................... Energy Service Provider.
Express Line.................. 345-kV circuit connecting Springerville
Unit 2 to the Tucson 138-kV system.
FAS 71........................ Statement of Financial Accounting Standards
No. 71: Accounting for the Effects of
Certain Types of Regulation.
FAS 133....................... Statement of Financial Accounting
Standards No 133: Accounting for Derivative
Instruments and Hedging Activities,
as amended.
FAS 143....................... Statement of Financial Accounting
Standards No. 143: Accounting for Asset
Retirement Obligations.
FERC.......................... Federal Energy Regulatory Commission.
First Collateral Trust Bonds.. Bonds issued under the Indenture of Trust,
dated as of August 1, 1998, of TEP to the
Bank of New York, successor trustee.
First Mortgage Bonds.......... First mortgage bonds issued under the
Indenture, dated as of April 1, 1941, of TEP
to J.P. Morgan Chase Bank, successor trustee,
as supplemented and amended.
Four Corners.................. Four Corners Generating Station.
Global Solar.................. Global Solar Energy, Inc., a company that
develops and manufactures thin-film
photovoltaic cells. Millennium owns 99% of
Global Solar.
Haddington.................... Haddington Energy Partners II, LP, a limited
partnership that funds energy-related
investments.
Heating Degree Days........... An index used to measure the impact of
weather on energy usage calculated by
subtracting the average of the high and low
daily temperatures from 65.
IDBs.......................... Industrial development revenue or pollution
control revenue bonds.
IPS........................... Infinite Power Solutions, Inc., a company
that develops thin-film batteries.
Millennium owns 72% of IPS.
IRS........................... Internal Revenue Service.
ISO........................... Independent System Operator.
ITC........................... Investment Tax Credit.
kWh........................... Kilowatt-hour(s).
kV............................ Kilovolt(s).
iv
LIBOR......................... London Interbank Offered Rate.
LOC........................... Letter of Credit.
Luna.......................... Luna Energy Facility.
MEG........................... Millennium Environment Group, Inc., a
wholly-owned subsidiary of Millennium,
which manages and trades emission
allowances, coal, and related
financial instruments.
MicroSat...................... MicroSat Systems, Inc. is a company
formed to develop and commercialize
small-scale satellites. Millennium
currently owns 35%.
Millennium.................... Millennium Energy Holdings, Inc.,
a wholly-owned subsidiary of
UniSource Energy.
Mimosa........................ Minerales de Monclova, S.A. de C.V.,
an owner of coal and associated gas
reserves and a supplier of
metallurgical coal to the steel
industry and thermal coal to the
Mexican electricity commission.
Sabinas owns 19.5% of Mimosa.
MMBtus........................ Million British Thermal Units.
MW............................ Megawatt(s).
MWh........................... Megawatt-hour(s).
Navajo........................ Navajo Generating Station.
NOL........................... Net Operating Loss carryback or
carryforward for income tax purposes.
PGA........................... Purchased Gas Adjustor, a retail rate
mechanism designed to recover the cost
of gas purchased for retail gas customers.
PNM........................... Public Service Company of New Mexico.
PNMR.......................... PNM Resources, Inc.
Powertrusion.................. POWERTRUSION International, Inc., a
company owned 77% by Millennium,
which manufactures lightweight utility poles.
PPFAC......................... Purchased Power and Fuel Adjustment Clause.
PWCC.......................... Pinnacle West Capital Corporation.
Repurchased Bonds............. $221 million of fixed-rate tax-exempt bonds
that TEP will purchase from bondholders on
May 11, 2005, pursuant to a tender offer
that expired on May 5, 2005.
RTO........................... Regional Transmission Organization.
Rules......................... Retail Electric Competition Rules.
Sabinas....................... Carboelectrica Sabinas, S. de R.L. de C.V.,
a Mexican limited liability company.
Millennium owns 50% of Sabinas.
Saguaro Utility............... An Arizona limited partnership, whose
general partner was Sage Mountain, L.L.C.
and whose limited partners included
investment funds affiliated with Kohlberg
Kravis Roberts & Co., L.P., J.P. Morgan
Partners, L.L.C. and Wachovia Capital
Partners.
San Carlos.................... San Carlos Resources Inc., a wholly-owned
subsidiary of TEP.
San Juan...................... San Juan Generating Station.
Second Mortgage Bonds......... TEP's second mortgage bonds issued under
the Indenture of Mortgage and Deed of Trust,
dated as of December 1, 1992, of TEP to The
Bank of New York, successor trustee, as
supplemented.
Sempra........................ Sempra Energy Trading Company.
SCE........................... Southern California Edison Company.
SES........................... Southwest Energy Solutions, Inc., a
wholly-owned subsidiary of Millennium.
Settlement Agreement.......... TEP's Settlement Agreement approved by the
ACC in November 1999 that provided for
electric retail competition and
transition asset recovery.
Springerville................. Springerville Generating Station.
Springerville Coal Handling
Facilities Leases........ Leveraged lease arrangements relating to the
coal handling facilities serving
Springerville.
Springerville Common
Facilities............... Facilities at Springerville used in common
with Springerville Unit 1 and Springerville
Unit 2.
Springerville Common
Facilities Leases........ Leveraged lease arrangements relating to an
undivided one-half interest in certain
Springerville Common Facilities.
Springerville Unit 1.......... Unit 1 of the Springerville Generating
Station.
v
Springerville Unit 1 Lease.... Leveraged lease arrangement relating to
Springerville Unit 1 and an undivided
one-half interest in certain Springerville
Common Facilities.
Springerville Unit 2.......... Unit 2 of the Springerville Generating
Station.
SRP........................... Salt River Project Agricultural Improvement
and Power District.
Sundt......................... H. Wilson Sundt Generating Station
(formerly known as the Irvington Generating
Station).
Sundt Lease................... The leveraged lease arrangement relating to
Sundt Unit 4.
SWG........................... Southwest Gas Corporation.
TEP........................... Tucson Electric Power Company, the principal
subsidiary of UniSource Energy.
TEP Credit Agreement.......... Credit Agreement between TEP and a syndicate
of banks, dated as of May 4, 2005.
TEP Revolving Credit Facility. $60 million revolving credit facility
entered into under the TEP Credit Agreement,
dated as of May 4, 2005, between a
syndicate of banks and TEP.
Therm......................... A unit of heating value equivalent to
100,000 British thermal units (Btu).
Tri-State..................... Tri-State Generation and Transmission
Association.
TruePricing................... TruePricing, Inc., a start-up company
established to market energy related
products.
UED........................... UniSource Energy Development Company,
a wholly-owned subsidiary of UniSource
Energy, which engages in developing
generation resources and other project
development services and related
activities.
UES........................... UniSource Energy Services, Inc., an
intermediate holding company
established to own the operating
companies (UNS Gas and UNS Electric)
which acquired the Citizens Arizona
gas and electric utility assets.
UniSource Credit Agreement.... Credit Agreement between UniSource Energy
and a syndicate of banks, dated
as of April 15, 2005.
UniSource Energy.............. UniSource Energy Corporation.
UNS Electric.................. UNS Electric, Inc., a wholly-owned
subsidiary of UES, which acquired
the Citizens Arizona electric utility assets.
UNS Gas....................... UNS Gas, Inc., a wholly-owned subsidiary of
UES, which acquired the Citizens Arizona gas
utility assets.
UNS Gas/UNS Electric Revolver. A $40 million revolving credit facility
entered into by UNS Gas and UNS Electric
on April 15, 2005.
Valencia...................... Valencia power plant owned by UNS Electric.
WestConnect................... The proposed for-profit RTO in which TEP is
a participant.
vi
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
UniSource Energy Corporation:
We have reviewed the accompanying condensed consolidated balance sheet of
UniSource Energy Corporation and its subsidiaries (the Company) as of March 31,
2005, and the related condensed consolidated statements of income (loss) and of
cash flows for each of the three-month periods ended March 31, 2005 and 2004 and
the condensed consolidated statement of changes in stockholders' equity for the
three-month period ended March 31, 2005. These interim financial statements are
the responsibility of the Company's management.
We conducted our review in accordance with the standards of the Public Company
Accounting Oversight Board (United States). A review of interim financial
information consists principally of applying analytical procedures and making
inquiries of persons responsible for financial and accounting matters. It is
substantially less in scope than an audit conducted in accordance with the
standards of the Public Company Accounting Oversight Board, the objective of
which is the expression of an opinion regarding the financial statements taken
as a whole. Accordingly, we do not express such an opinion.
Based on our review, we are not aware of any material modifications that should
be made to the accompanying condensed consolidated interim financial statements
for them to be in conformity with accounting principles generally accepted in
the United States of America.
We have previously audited, in accordance with the standards of the Public
Company Accounting Oversight Board (United States), the consolidated balance
sheet as of December 31, 2004, and the related consolidated statements of
income, of cash flows and of changes in stockholders' equity for the year then
ended, management's assessment of the effectiveness of the Company's internal
control over financial reporting as of December 31, 2004 and the effectiveness
of the Company's internal control over financial reporting as of December 31,
2004; and in our report dated March 16, 2005, we expressed unqualified opinions
thereon. The consolidated financial statements and management's assessment of
the effectiveness of internal control over financial reporting referred to above
are not presented herein. In our opinion, the information set forth in the
accompanying consolidated balance sheet information as of March 31, 2005, is
fairly stated in all material respects in relation to the consolidated balance
sheet from which it has been derived.
PRICEWATERHOUSECOOPERS LLP
Los Angeles, California
May 6, 2005
1
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
Tucson Electric Power Company:
We have reviewed the accompanying condensed consolidated balance sheet of Tucson
Electric Power Company (the Company) as of March 31, 2005, and the related
condensed consolidated statements of income (loss) and of cash flows for each of
the three-month periods ended March 31, 2005 and 2004 and the condensed
consolidated statement of changes in stockholders' equity for the three-month
period ended March 31, 2005. These interim financial statements are the
responsibility of the Company's management.
We conducted our review in accordance with the standards of the Public Company
Accounting Oversight Board (United States). A review of interim financial
information consists principally of applying analytical procedures and making
inquiries of persons responsible for financial and accounting matters. It is
substantially less in scope than an audit conducted in accordance with the
standards of the Public Company Accounting Oversight Board, the objective of
which is the expression of an opinion regarding the financial statements taken
as a whole. Accordingly, we do not express such an opinion.
Based on our review, we are not aware of any material modifications that should
be made to the accompanying condensed consolidated interim financial statements
for them to be in conformity with accounting principles generally accepted in
the United States of America.
We previously audited in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the consolidated balance sheet as of
December 31, 2004, and the related consolidated statements of income, of cash
flows, and of changes in stockholders' equity for the year then ended (not
presented herein), and in our report dated March 16, 2005 we expressed an
unqualified opinion on those consolidated financial statements. In our opinion,
the information set forth in the accompanying consolidated balance sheet
information as of March 31, 2005, is fairly stated in all material respects in
relation to the consolidated balance sheet from which it has been derived.
PRICEWATERHOUSECOOPERS LLP
Los Angeles, California
May 6, 2005
2
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
UNISOURCE ENERGY CORPORATION
COMPARATIVE CONDENSED CONSOLIDATED STATEMENTS OF INCOME (LOSS)
Three Months Ended
March 31,
2005 2004
(UNAUDITED)
-------------------------------------------------------------------------------------------------
-Thousands of Dollars-
OPERATING REVENUES
Electric Retail Sales $ 171,590 $ 174,363
Electric Wholesale Sales 39,180 41,700
Gas Revenue 46,549 48,801
Other Revenues 3,610 5,220
-------------------------------------------------------------------------------------------------
TOTAL OPERATING REVENUES 260,929 270,084
-------------------------------------------------------------------------------------------------
OPERATING EXPENSES
Fuel 47,291 47,449
Purchased Energy 64,407 59,502
Other Operations and Maintenance 61,492 63,579
Depreciation and Amortization 34,824 35,136
Amortization of Transition Recovery Asset 9,487 8,597
Taxes Other Than Income Taxes 13,499 13,111
-------------------------------------------------------------------------------------------------
TOTAL OPERATING EXPENSES 231,000 227,374
-------------------------------------------------------------------------------------------------
OPERATING INCOME 29,929 42,710
-------------------------------------------------------------------------------------------------
OTHER INCOME (DEDUCTIONS)
Interest Income 4,961 4,869
Other Income 2,261 8,715
Other Expense (2,351) (1,016)
-------------------------------------------------------------------------------------------------
TOTAL OTHER INCOME (DEDUCTIONS) 4,871 12,568
-------------------------------------------------------------------------------------------------
INTEREST EXPENSE
Long-Term Debt 20,352 23,118
Interest on Capital Leases 19,746 20,044
Other Interest Expense, Net of Amounts Capitalized 11 (214)
-------------------------------------------------------------------------------------------------
TOTAL INTEREST EXPENSE 40,109 42,948
-------------------------------------------------------------------------------------------------
INCOME (LOSS) BEFORE INCOME TAXES (5,309) 12,330
Income Tax Expense (Benefit) (1,526) 5,909
-------------------------------------------------------------------------------------------------
NET INCOME (LOSS) $ (3,783) $ 6,421
=================================================================================================
WEIGHTED-AVERAGE SHARES OF COMMON STOCK OUTSTANDING (000) 34,635 34,185
=================================================================================================
BASIC EARNINGS (LOSS) PER SHARE $ (0.11) $ 0.19
=================================================================================================
DILUTED EARNINGS (LOSS) PER SHARE $ (0.11) $ 0.18
=================================================================================================
DIVIDENDS PAID PER SHARE $ 0.19 $ 0.16
=================================================================================================
See Notes to Condensed Consolidated Financial Statements.
3
UNISOURCE ENERGY CORPORATION
COMPARATIVE CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
Three Months Ended
March 31,
2005 2004
(UNAUDITED)
-------------------------------------------------------------------------------------------------
-Thousands of Dollars-
CASH FLOWS FROM OPERATING ACTIVITIES
Cash Receipts from Electric Retail Sales $ 206,194 $ 200,489
Cash Receipts from Electric Wholesale Sales 52,111 56,327
Cash Receipts from Gas Sales 55,568 56,981
MEG Cash Receipts from Trading Activity 38,566 34,357
Interest Received 10,488 10,504
Income Tax Refunds Received 928 286
Performance Deposits 6,349 (7,052)
Other Cash Receipts 2,666 4,121
Fuel Costs Paid (48,503) (46,073)
Purchased Energy Costs Paid (82,143) (76,681)
Wages Paid, Net of Amounts Capitalized (29,336) (25,051)
Payment of Other Operations and Maintenance Costs (39,059) (35,905)
MEG Cash Payments for Trading Activity (39,044) (28,278)
Capital Lease Interest Paid (38,387) (40,308)
Taxes Paid, Net of Amounts Capitalized (22,774) (22,336)
Interest Paid, Net of Amounts Capitalized (29,142) (30,135)
Income Taxes Paid (3,500) (7,000)
Other Cash Payments (930) (207)
-------------------------------------------------------------------------------------------------
NET CASH FLOWS - OPERATING ACTIVITIES 40,052 44,039
-------------------------------------------------------------------------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES
Capital Expenditures (44,872) (31,370)
Proceeds from Investment in Springerville Lease Debt and Equity 8,251 8,054
Other Cash Receipts 5,616 -
Investment in and Loans to Equity Investees (216) (628)
Return of Investment from Millennium Energy Business - 267
Payments for Investment in Springerville Lease Debt and Equity - (4,499)
Other Cash Payments - (4)
-------------------------------------------------------------------------------------------------
NET CASH FLOWS - INVESTING ACTIVITIES (31,221) (28,180)
-------------------------------------------------------------------------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from Issuance of Long-Term Debt 150,000 -
Repayments of Long-Term Debt (53,150) (1,232)
Payments on Capital Lease Obligations (48,377) (43,632)
Proceeds from Borrowings under Revolving Credit Facility - 20,000
Payments on Borrowings under Revolving Credit Facility - (20,000)
Other Cash Receipts 5,960 4,615
Payment of Debt Issue/Retirement Costs (5,126) (8,959)
Common Stock Dividends Paid (6,537) (5,439)
Other Cash Payments (1,375) (1,253)
-------------------------------------------------------------------------------------------------
NET CASH FLOWS - FINANCING ACTIVITIES 41,395 (55,900)
-------------------------------------------------------------------------------------------------
Net Increase (Decrease) in Cash and Cash Equivalents 50,226 (40,041)
Cash and Cash Equivalents, Beginning of Year 154,028 101,266
-------------------------------------------------------------------------------------------------
CASH AND CASH EQUIVALENTS, END OF PERIOD $ 204,254 $ 61,225
=================================================================================================
See Note 13 for supplemental cash flow information.
See Notes to Condensed Consolidated Financial Statements.
4
UNISOURCE ENERGY CORPORATION
COMPARATIVE CONDENSED CONSOLIDATED BALANCE SHEETS
March 31, December 31,
2005 2004
(UNAUDITED)
-------------------------------------------------------------------------------------------------
ASSETS - Thousands of Dollars -
UTILITY PLANT
Plant in Service $ 3,064,432 $ 3,033,405
Utility Plant under Capital Leases 723,901 723,901
Construction Work in Progress 126,633 116,161
-------------------------------------------------------------------------------------------------
TOTAL UTILITY PLANT 3,914,966 3,873,467
Less Accumulated Depreciation and Amortization (1,377,294) (1,348,017)
Less Accumulated Amortization of Capital Lease Assets (451,323) (444,313)
-------------------------------------------------------------------------------------------------
TOTAL UTILITY PLANT - NET 2,086,349 2,081,137
-------------------------------------------------------------------------------------------------
INVESTMENTS AND OTHER PROPERTY
Investments in Lease Debt and Equity 162,406 170,893
Other 82,642 85,035
-------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS AND OTHER PROPERTY 245,048 255,928
-------------------------------------------------------------------------------------------------
CURRENT ASSETS
Cash and Cash Equivalents 204,254 154,028
Trade Accounts Receivable 87,652 107,694
Unbilled Accounts Receivable 39,861 55,350
Allowance for Doubtful Accounts (16,604) (16,492)
Materials and Fuel Inventory 67,593 62,225
Trading Assets 50,761 70,958
Current Regulatory Assets 9,922 9,653
Income Taxes Receivable 6,045 -
Deferred Income Taxes - Current 14,719 24,055
Interest Receivable - Current 5,409 10,475
Other 21,290 26,751
-------------------------------------------------------------------------------------------------
TOTAL CURRENT ASSETS 490,902 504,697
-------------------------------------------------------------------------------------------------
REGULATORY AND OTHER ASSETS
Transition Recovery Asset 214,541 224,029
Income Taxes Recoverable Through Future Revenues 43,498 44,624
Other Regulatory Assets 16,693 15,823
Other Assets 55,735 49,280
-------------------------------------------------------------------------------------------------
TOTAL REGULATORY AND OTHER ASSETS 330,467 333,756
-------------------------------------------------------------------------------------------------
TOTAL ASSETS $ 3,152,766 $ 3,175,518
=================================================================================================
CAPITALIZATION AND OTHER LIABILITIES
CAPITALIZATION
Common Stock Equity $ 578,524 $ 580,718
Capital Lease Obligations 655,957 701,931
Long-Term Debt 1,356,170 1,257,595
-------------------------------------------------------------------------------------------------
TOTAL CAPITALIZATION 2,590,651 2,540,244
-------------------------------------------------------------------------------------------------
CURRENT LIABILITIES
Current Obligations under Capital Leases 56,227 53,694
Current Maturities of Long-Term Debt - 1,725
Accounts Payable 62,159 95,276
Interest Accrued 26,414 60,679
Trading Liabilities 50,962 65,022
Taxes Accrued 45,528 53,192
Accrued Employee Expenses 14,479 19,216
Customer Deposits 15,183 14,794
Other 6,794 4,556
-------------------------------------------------------------------------------------------------
TOTAL CURRENT LIABILITIES 277,746 368,154
-------------------------------------------------------------------------------------------------
DEFERRED CREDITS AND OTHER LIABILITIES
Deferred Income Taxes - Noncurrent 113,212 101,753
Regulatory Liability - Net Cost of Removal for Interim Retirements 71,795 69,585
Other 99,362 95,782
-------------------------------------------------------------------------------------------------
TOTAL DEFERRED CREDITS AND OTHER LIABILITIES 284,369 267,120
-------------------------------------------------------------------------------------------------
COMMITMENTS AND CONTINGENCIES (NOTE 6)
-------------------------------------------------------------------------------------------------
TOTAL CAPITALIZATION AND OTHER LIABILITIES $ 3,152,766 $ 3,175,518
=================================================================================================
See Notes to Condensed Consolidated Financial Statements.
5
UNISOURCE ENERGY CORPORATION
CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
Accumulated
Common Accumulated Other Total
Shares Common Earnings Comprehensive Stockholders'
Outstanding* Stock (Deficit) Income (Loss) Equity
------------------------------------------------------------------------------------------------------------------------------------
(UNAUDITED)
- Thousands of Dollars -
BALANCES AT DECEMBER 31, 2004 34,255 $ 677,119 $ (85,666) $ (10,735) $ 580,718
------------------------------------------------------------------------------------------------------------------------------------
Comprehensive Income (Loss):
2005 Year-to-Date Net Loss - - (3,783) - (3,783)
Unrealized Gain on Cash Flow Hedges
(net of $2,315 income tax expense) - - - 3,531 3,531
Reclassification of Realized Gain on
Cash Flow Hedges to Net Income
(net of $48 income tax expense) - - - (73) (73)
--------------
Total Comprehensive Loss (325)
--------------
Dividends Declared - - (6,537) - (6,537)
Shares Issued under Stock Compensation Plans 37 - - - -
Shares Issued for Stock Options 212 4,538 - - 4,538
Other - 130 - - 130
------------------------------------------------------------------------------------------------------------------------------------
BALANCES AT MARCH 31, 2005 34,504 $ 681,787 $ (95,986) $ (7,277) $ 578,524
====================================================================================================================================
* UniSource Energy has 75 million authorized shares of common stock.
See Notes to Condensed Consolidated Financial Statements.
6
TUCSON ELECTRIC POWER COMPANY
COMPARATIVE CONDENSED CONSOLIDATED STATEMENTS OF INCOME (LOSS)
Three Months Ended
March 31,
2005 2004
(UNAUDITED)
-------------------------------------------------------------------------------------------------
-Thousands of Dollars-
OPERATING REVENUES
Electric Retail Sales $ 140,206 $ 143,176
Electric Wholesale Sales 39,128 41,649
Other Revenues 2,572 2,149
-------------------------------------------------------------------------------------------------
TOTAL OPERATING REVENUES 181,906 186,974
-------------------------------------------------------------------------------------------------
OPERATING EXPENSES
Fuel 47,291 47,449
Purchased Power 12,861 6,252
Other Operations and Maintenance 47,977 47,829
Depreciation and Amortization 30,020 30,413
Amortization of Transition Recovery Asset 9,487 8,597
Taxes Other Than Income Taxes 11,149 10,746
-------------------------------------------------------------------------------------------------
TOTAL OPERATING EXPENSES 158,785 151,286
-------------------------------------------------------------------------------------------------
OPERATING INCOME 23,121 35,688
-------------------------------------------------------------------------------------------------
OTHER INCOME (DEDUCTIONS)
Interest Income 4,816 4,861
Interest Income - Note Receivable from UniSource Energy 1,684 2,320
Other Income 1,765 1,164
Other Expense (1,432) (936)
-------------------------------------------------------------------------------------------------
TOTAL OTHER INCOME (DEDUCTIONS) 6,833 7,409
-------------------------------------------------------------------------------------------------
INTEREST EXPENSE
Long-Term Debt 16,979 20,381
Interest on Capital Leases 19,737 20,037
Other Interest Expense, Net of Amounts Capitalized 90 (189)
-------------------------------------------------------------------------------------------------
TOTAL INTEREST EXPENSE 36,806 40,229
-------------------------------------------------------------------------------------------------
INCOME (LOSS) BEFORE INCOME TAXES (6,852) 2,868
Income Tax Expense (Benefit) (2,162) 2,074
-------------------------------------------------------------------------------------------------
NET INCOME (LOSS) $ (4,690) $ 794
=================================================================================================
See Notes to Condensed Consolidated Financial Statements.
7
TUCSON ELECTRIC POWER COMPANY
COMPARATIVE CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
Three Months Ended
March 31,
2005 2004
(UNAUDITED)
-------------------------------------------------------------------------------------------------
-Thousands of Dollars-
Cash Flows from Operating Activities
Cash Receipts from Electric Retail Sales $ 168,807 $ 165,683
Cash Receipts from Electric Wholesale Sales 52,047 56,258
Interest Received 10,327 10,452
Interest Received -- UniSource 11,013 -
Other Cash Receipts 1,090 1,257
Income Taxes Refunds Received 713 286
Fuel Costs Paid (48,503) (46,073)
Purchased Power Costs Paid (24,763) (22,380)
Wages Paid, Net of Amounts Capitalized (22,949) (17,985)
Payment of Other Operations and Maintenance Costs (32,983) (27,868)
Capital Lease Interest Paid (38,378) (40,304)
Taxes Paid, Net of Amounts Capitalized (14,325) (13,841)
Interest Paid, Net of Amounts Capitalized (24,059) (24,949)
Income Taxes Paid - (5,000)
Other Cash Payments (766) -
-------------------------------------------------------------------------------------------------
NET CASH FLOWS - OPERATING ACTIVITIES 37,271 35,536
-------------------------------------------------------------------------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES
Capital Expenditures (33,513) (22,956)
Proceeds from Investment in Springerville Lease Debt and Equity 8,251 8,054
Payments for Investment in Springerville Lease Debt and Equity - (4,499)
Other Cash Receipts 5,000 -
-------------------------------------------------------------------------------------------------
NET CASH FLOWS - INVESTING ACTIVITIES (20,262) (19,401)
-------------------------------------------------------------------------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from Repayment of UniSource Energy Note 95,393 -
Repayments of Long-Term Debt (53,150) (1,225)
Payments on Capital Lease Obligations (48,357) (43,599)
Proceeds from Borrowings under Revolving Credit Facility - 20,000
Payments on Borrowings under Revolving Credit Facility - (20,000)
Other Cash Receipts 1,532 3,269
Payment of Debt Issue/Retirement Costs (122) (8,583)
Other Cash Payments (5,920) (423)
-------------------------------------------------------------------------------------------------
NET CASH FLOWS - FINANCING ACTIVITIES (10,624) (50,561)
-------------------------------------------------------------------------------------------------
Net Increase (Decrease) in Cash and Cash Equivalents 6,385 (34,426)
Cash and Cash Equivalents, Beginning of Year 113,207 65,262
-------------------------------------------------------------------------------------------------
CASH AND CASH EQUIVALENTS, END OF PERIOD $ 119,592 $ 30,836
=================================================================================================
See Note 13 for supplemental cash flow information.
See Notes to Condensed Consolidated Financial Statements.
8
TUCSON ELECTRIC POWER COMPANY
COMPARATIVE CONDENSED CONSOLIDATED BALANCE SHEETS
March 31, December 31,
2005 2004
(UNAUDITED)
-------------------------------------------------------------------------------------------------
ASSETS - Thousands of Dollars -
UTILITY PLANT
Plant in Service $ 2,793,624 $ 2,771,665
Utility Plant under Capital Leases 723,195 723,195
Construction Work in Progress 104,844 94,336
-------------------------------------------------------------------------------------------------
TOTAL UTILITY PLANT 3,621,663 3,589,196
Less Accumulated Depreciation and Amortization (1,353,442) (1,328,228)
Less Accumulated Amortization of Capital Lease Assets (451,173) (444,186)
-------------------------------------------------------------------------------------------------
TOTAL UTILITY PLANT - NET 1,817,048 1,816,782
-------------------------------------------------------------------------------------------------
INVESTMENTS AND OTHER PROPERTY
Investments in Lease Debt and Equity 162,406 170,893
Other 23,284 23,393
-------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS AND OTHER PROPERTY 185,690 194,286
-------------------------------------------------------------------------------------------------
NOTE RECEIVABLE FROM UNISOURCE ENERGY - 79,462
-------------------------------------------------------------------------------------------------
CURRENT ASSETS
Cash and Cash Equivalents 119,592 113,207
Trade Accounts Receivable 67,719 72,042
Unbilled Accounts Receivable 23,061 33,179
Allowance for Doubtful Accounts (14,301) (14,166)
Intercompany Accounts Receivable 7,962 10,111
Materials and Fuel Inventory 54,580 51,207
Current Regulatory Assets 9,922 9,653
Income Taxes Receivable 6,972 -
Deferred Income Taxes - Current 15,030 24,157
Interest Receivable - Current 5,405 10,475
Other 15,895 18,330
-------------------------------------------------------------------------------------------------
TOTAL CURRENT ASSETS 311,837 328,195
-------------------------------------------------------------------------------------------------
REGULATORY AND OTHER ASSETS
Transition Recovery Asset 214,541 224,029
Income Taxes Recoverable Through Future Revenues 43,498 44,624
Other Regulatory Assets 14,103 13,684
Other Assets 42,728 41,106
-------------------------------------------------------------------------------------------------
TOTAL REGULATORY AND OTHER ASSETS 314,870 323,443
-------------------------------------------------------------------------------------------------
TOTAL ASSETS $ 2,629,445 $ 2,742,168
=================================================================================================
CAPITALIZATION AND OTHER LIABILITIES
CAPITALIZATION
Common Stock Equity $ 439,934 $ 414,510
Capital Lease Obligations 655,453 701,405
Long-Term Debt 1,046,170 1,097,595
-------------------------------------------------------------------------------------------------
TOTAL CAPITALIZATION 2,141,557 2,213,510
-------------------------------------------------------------------------------------------------
CURRENT LIABILITIES
Current Obligations under Capital Leases 56,143 53,611
Current Maturities of Long-Term Debt - 1,725
Accounts Payable 37,649 46,377
Intercompany Accounts Payable 9,816 20,026
Interest Accrued 24,406 56,514
Taxes Accrued 36,712 44,938
Accrued Employee Expenses 12,553 17,594
Other 12,015 9,592
-------------------------------------------------------------------------------------------------
TOTAL CURRENT LIABILITIES 189,294 250,377
-------------------------------------------------------------------------------------------------
DEFERRED CREDITS AND OTHER LIABILITIES
Deferred Income Taxes - Noncurrent 145,195 129,842
Regulatory Liability - Net Cost of Removal for Interim Retirements 69,306 67,485
Other 84,093 80,954
-------------------------------------------------------------------------------------------------
TOTAL DEFERRED CREDITS AND OTHER LIABILITIES 298,594 278,281
-------------------------------------------------------------------------------------------------
COMMITMENTS AND CONTINGENCIES (NOTE 6)
-------------------------------------------------------------------------------------------------
TOTAL CAPITALIZATION AND OTHER LIABILITIES $ 2,629,445 $ 2,742,168
=================================================================================================
See Notes to Condensed Consolidated Financial Statements.
9
TUCSON ELECTRIC POWER COMPANY
CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
Accumulated
Capital Accumulated Other Total
Common Stock Earnings Comprehensive Stockholders'
Stock Expense (Deficit) Income (Loss) Equity
------------------------------------------------------------------------------------------------------------------------------------
(UNAUDITED)
- Thousands of Dollars -
BALANCES AT DECEMBER 31, 2004 $ 658,254 $ (6,357) $(226,652) $ (10,735) $ 414,510
------------------------------------------------------------------------------------------------------------------------------------
Comprehensive Income:
2005 Year-to-Date Net Loss - - (4,690) - (4,690)
Unrealized Gain on Cash Flow Hedges
(net of $2,315 income tax expense) - - - 3,531 3,531
Reclassification of Realized Gain on
Cash Flow Hedges to Net Income
(net of $48 income tax expense) - - - (73) (73)
----------------
Total Comprehensive Loss (1,232)
----------------
Equity Contribution from UniSource Energy (Note 3) 25,261 - - - 25,261
Capital Contribution from UniSource Energy 1,395 - - - 1,395
------------------------------------------------------------------------------------------------------------------------------------
BALANCES AT MARCH 31, 2005 $ 684,910 $ (6,357) $(231,342) $ (7,277) $ 439,934
====================================================================================================================================
See Notes to Condensed Consolidated Financial Statements.
10
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
NOTE 1. NATURE OF OPERATIONS, BASIS OF ACCOUNTING PRESENTATION AND EQUITY-BASED
COMPENSATION
UniSource Energy Corporation (UniSource Energy) is an exempt holding
company under the Public Utility Holding Company Act of 1935. UniSource Energy
has no significant operations of its own, but owns substantially all of the
common stock of Tucson Electric Power Company (TEP) and all of the common stock
of UniSource Energy Services, Inc. (UES), Millennium Energy Holdings, Inc.
(Millennium) and UniSource Energy Development Company (UED).
TEP, a regulated public utility incorporated in Arizona since 1963, is
UniSource Energy's largest operating subsidiary and represented approximately
84% of UniSource Energy's assets as of March 31, 2005. TEP generates, transmits
and distributes electricity. TEP serves approximately 378,000 retail electric
customers in a 1,155 square mile area in Southern Arizona. TEP also sells
electricity to other utilities and power marketing entities primarily located in
the western U.S.
UES holds the common stock of UNS Gas, Inc. (UNS Gas) and UNS Electric,
Inc. (UNS Electric). UES has no significant operations of its own. UNS Gas is a
gas distribution company serving approximately 135,600 retail customers in
Mohave, Yavapai, Coconino, and Navajo Counties in northern Arizona, as well as
Santa Cruz County in southeast Arizona. UNS Electric is an electric transmission
and distribution company serving approximately 86,500 retail customers in Mohave
and Santa Cruz counties.
Millennium invests in unregulated businesses, including Global Solar Energy
(Global Solar), a developer and manufacturer of thin-film photovoltaic cells and
modules. UED engages in developing generating resources and other project
development activities, including facilitating the expansion of the
Springerville Generating Station, but has no significant operations.
We conduct our business in four primary business segments - TEP's Electric
Utility segment, UNS Gas, UNS Electric and Global Solar.
References to "we" and "our" are to UniSource Energy and its subsidiaries,
collectively.
The accompanying quarterly financial statements of UniSource Energy and TEP
are unaudited but reflect all normal recurring accruals and other adjustments
which we believe are necessary for a fair presentation of the results for the
interim periods presented. These financial statements are presented in
accordance with the Securities and Exchange Commission's (SEC) interim reporting
requirements which do not include all the disclosures required by accounting
principles generally accepted in the United States of America (GAAP) for audited
annual financial statements. The year-end condensed balance sheet data was
derived from audited financial statements, but does not include disclosures
required by GAAP for audited annual financial statements. This quarterly report
should be reviewed in conjunction with UniSource Energy and TEP's 2004 Annual
Report on Form 10-K.
Weather, among other factors, causes seasonal fluctuations in TEP, UNS Gas
and UNS Electric's sales; therefore, quarterly results are not indicative of
annual operating results. UniSource Energy and TEP have made minor
reclassifications to the prior year financial statements for comparative
purposes. These reclassifications had no effect on net income.
EQUITY-BASED COMPENSATION
UniSource Energy has two equity-based compensation plans, the 1994 Outside
Director Stock Option Plan (Directors' Plan) and the 1994 Omnibus Stock and
Incentive Plan (Omnibus Plan). See Note 10. We early adopted Statement of
Financial Accounting Standards No. 123(R), Share Based Payment (FAS 123(R))
effective January 1, 2005. The adoption of FAS 123(R) did not have a significant
impact on our financial statements because stock options issued under UniSource
Energy's Omnibus Plan vested upon the shareholder vote to approve the proposed
acquisition of UniSource Energy, see UniSource Energy's 2004 Annual Report on
Form 10-K, Note 17 in Notes to Consolidated Financial Statements - Stock-Based
Compensation. In addition, no new stock options can be issued under the Omnibus
Plan after 2004. Prior to January 1, 2005, we accounted for those plans under
the recognition and measurement principles of APB Opinion No. 25, Accounting for
Stock Issued to Employees (APB 25), and related interpretations.
11
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
Prior to January 1, 2005, our stock options were granted with an exercise
price equal to the market value of the stock at the date of the grant.
Accordingly, under the provisions of APB 25 no compensation expense was recorded
for these awards. However, compensation expense was recognized for restricted
stock, stock unit and performance share awards over the performance/vesting
period.
The following table illustrates the effect on UniSource Energy's net income
and earnings per share and TEP's net income as if we had applied the fair value
recognition provisions of FAS 123(R) to all equity-based employee compensation
awards for the three months ended March 31, 2004:
UNISOURCE ENERGY:
----------------
Three Months Ended March 31,
-------------------------------------------------------------------------------------------------------
2004
-------------------------------------------------------------------------------------------------------
-Thousands of Dollars-
(except per share data)
Net Income - As Reported $ 6,421
Add: Equity-based compensation expense included in reported net
income, net of related tax effects 1,243
Deduct: Total equity-based employee compensation expense
determined under fair value based method for all awards, net
of related tax effects (1,866)
-------------------------------------------------------------------------------------------------------
Pro Forma Net Income $ 5,798
=======================================================================================================
Basic Earnings per Share:
As Reported $0.19
Pro Forma $0.17
=======================================================================================================
Diluted Earnings per Share:
As Reported $0.18
Pro Forma $0.17
=======================================================================================================
TEP:
----
Three Months Ended March 31,
-------------------------------------------------------------------------------------------------------
2004
-------------------------------------------------------------------------------------------------------
-Thousands of Dollars-
Net Income - As Reported $ 794
Add: Equity-based compensation expense included in reported net
income, net of related tax effects 1,119
Deduct: Total equity-based employee compensation expense
determined under fair value based method for all awards, net
of related tax effects (1,730)
-------------------------------------------------------------------------------------------------------
Pro Forma Net Income $ 183
=======================================================================================================
The fair value of each stock option grant is estimated on the date of grant
using the Black-Scholes option-pricing model. There were no stock options
granted in the first quarter of 2004. For the 21,222 options granted under the
Directors' Plan in 2003, the following weighted average assumptions were used:
2003
-------------------------------------------------------------------------------------------------------
Expected life (years) 6
Interest rate 3.34%
Volatility 23.74%
Dividend yield 3.55%
Weighted-average grant-date fair value of options
granted during the period $3.16
-------------------------------------------------------------------------------------------------------
12
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
NOTE 2. REGULATORY MATTERS
---------------------------
REGULATORY ACCOUNTING
TEP, UNS Gas and UNS Electric generally use the same accounting policies
and practices used by unregulated companies for financial reporting under GAAP.
However, sometimes these principles, such as Statement of Financial Accounting
Standards No. 71, Accounting for the Effects of Certain Types of Regulation (FAS
71), require special accounting treatment for regulated companies to show the
effect of regulation. For example, in setting TEP, UNS Gas and UNS Electric's
retail rates, the Arizona Corporation Commission (ACC) may not allow TEP, UNS
Gas or UNS Electric to currently charge their customers to recover certain
expenses, but instead requires that these expenses be charged to customers in
the future. In this situation, FAS 71 requires that TEP and UES defer these
items and show them as regulatory assets on the balance sheet until TEP, UNS Gas
and UNS Electric are allowed to charge their customers. TEP, UNS Gas and UNS
Electric then amortize these items as expense to the income statement as these
charges are recovered from customers. Similarly, certain revenue items may be
deferred as regulatory liabilities, which are also eventually amortized to the
income statement as rates to customers are reduced.
The conditions a regulated company must satisfy to apply the accounting
policies and practices of FAS 71 include:
o an independent regulator sets rates;
o the regulator sets the rates to recover specific costs of delivering
service; and
o the service territory lacks competitive pressures to reduce rates
below the rates set by the regulator.
IMPLICATIONS OF DISCONTINUING APPLICATION OF FAS 71
TEP
Upon approval by the ACC of a settlement agreement (TEP Settlement
Agreement) in November 1999, TEP discontinued application of FAS 71 for its
generation operations. TEP continues to apply FAS 71 to its regulated
operations, which include the transmission and distribution portions of its
business.
TEP's transmission and distribution regulatory assets, net of regulatory
liabilities, totaled $213 million at March 31, 2005. Regulatory assets of $24
million are not presently included in rate base and consequently are not earning
a return on investment. TEP's transmission and distribution regulatory assets,
net of regulatory liabilities, totaled $225 million at December 31, 2004.
TEP regularly assesses whether it can continue to apply FAS 71 to its
regulated operations. If TEP stopped applying FAS 71 to these operations, it
would write off the related balances of its regulatory assets as an expense and
its regulatory liabilities as income on its income statement. Based on the
regulatory asset balances, net of regulatory liabilities, at March 31, 2005, if
TEP had stopped applying FAS 71 to its remaining regulated operations, it would
have recorded an extraordinary after-tax loss of $129 million. While regulatory
orders and market conditions may affect cash flows, TEP's cash flows would not
be affected if it stopped applying FAS 71 unless a regulatory order limited its
ability to recover the cost of its regulatory assets.
UNS GAS AND UNS ELECTRIC
UNS Gas and UNS Electric's regulatory liabilities exceed their regulatory
assets by $5 million at March 31, 2005. At December 31, 2004, UNS Gas and UNS
Electric's regulatory assets, net of regulatory liabilities, totaled $4 million.
UNS Gas and UNS Electric's regulatory assets and liabilities are included in
rate base and consequently are earning a return on investment. If UNS Gas and
UNS Electric stopped applying FAS 71 to their regulated operations, they would
write off the related balances of their regulatory assets as an expense and
would write off their regulatory liabilities as income on their income
statements. Based on the regulatory asset and liability balances, if UNS Gas and
UNS Electric had stopped applying FAS 71 to their regulated operations, they
would have recorded an extraordinary after-tax gain of $3 million at March 31,
2005. UNS Gas and UNS Electric's cash flows would not be affected if they
stopped applying FAS 71 unless a regulatory order limited their ability to
recover the cost of their regulatory assets.
13
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
RECENT REGULATORY ACTION
TEP
Given recent court action, the ACC may revise its Rules and rate
methodologies prior to the expiration in 2008 of the TEP Settlement Agreement. A
new structure could replace that established pursuant to the TEP Settlement
Agreement prior to January 2009.
In an effort to resolve the uncertainty surrounding the continued
applicability of the Rules and the methodology that will be applied to determine
TEP's rates for generation service after the CTCs expire, TEP filed a motion
with the ACC on May 4, 2005 requesting that the ACC issue an order declaring its
position regarding the status of the Rules and the rate treatment that will be
afforded to TEP's generation assets after 2008.
The motion states TEP's preference for the ACC to adhere to the 1999
Settlement Agreement and continue to authorize TEP to charge market-based rates
for generation services after December 31, 2008. The motion also states that, if
the ACC intends to rescind TEP's authorization to charge market-based rates for
its generation services, that change will have immediate consequences for the
Settlement Agreement, the 2004 general rate case information filing and future
TEP rate cases. Accordingly, TEP requested that the ACC clarify its intentions
in this regard. In addition, TEP requested that a procedural conference be held
in the 2004 rate review proceedings to discuss the status of that case pending
the issuance of an order in response to TEP's motion. TEP cannot predict when,
or how, the ACC will respond to the motion.
UES
In January 2005, UNS Gas requested the ACC approve a PGA surcharge of $0.06
per therm beginning April 1, 2005 and removed one year later, to recover its
excess gas purchase costs. The previous PGA surcharge of $0.1155 per therm took
effect October 1, 2003 and ended November 1, 2004. On March 31, 2005, the ACC
approved a PGA surcharge of $0.03 per therm beginning April 11, 2005 and lasting
until the excess gas purchase costs are fully recovered. Based on the rates
currently in effect, we do not expect the PGA balance to be fully recovered
until 2008. The under recovered gas purchase costs of $2.3 million as of March
31, 2005, are recorded in Other Regulatory Assets on UniSource Energy's balance
sheet.
NOTE 3. DEBT AND CREDIT FACILITIES
-----------------------------------
Long-term debt matures more than one year from the date of the financial
statements.
UNISOURCE ENERGY DEBT
CONVERTIBLE SENIOR NOTES
On March 1, 2005, UniSource Energy issued $150 million aggregate principal
amount of 4.50% Convertible Senior Notes (Convertible Senior Notes) due 2035 in
a private placement. The Convertible Senior Notes are unsecured. Each $1,000
principal amount of Convertible Senior Notes is convertible into 26.6667 shares
of UniSource Energy Common Stock at any time, representing a conversion price of
approximately $37.50 per share of our Common Stock, subject to adjustment in
certain circumstances.
The Convertible Senior Notes bear interest at an annual rate of 4.50%
payable semi-annually in arrears on each March 1 and September 1, commencing on
September 1, 2005. In addition, beginning on March 1, 2015, the Convertible
Senior Notes will also, in certain circumstances, bear contingent interest at
the annual rate of 0.35%.
Beginning on March 5, 2010, we will have the option to redeem the
Convertible Senior Notes, in whole or in part, for cash, at a price equal to
100% of the principal amount plus accrued interest. If certain change of control
transactions occur, or our common stock is no longer listed on a national
securities exchange, holders of the Convertible Senior Notes may require
UniSource Energy to repurchase the Convertible Senior Notes, in whole or in
14
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
part, for cash. If one of these events occurs prior to March 5, 2010, we may be
required to pay a make-whole premium payable in shares of common stock.
Additionally, the holders of the Convertible Senior Notes may require us to
repurchase for cash, all or part, of the Convertible Senior Notes on March 1,
2015, 2020, 2025 and 2030. The repurchase price will be 100% of the principal
amount of the Convertible Senior Notes plus accrued interest.
The Convertible Senior Notes may become immediately payable if an event of
default occurs. An event of default includes failure to make required payments
on the Convertible Senior Notes, acceleration of $50 million or more of
indebtedness for borrowed money at UniSource Energy or TEP or certain bankruptcy
events at UniSource Energy or TEP. Neither TEP nor any other subsidiary of
UniSource Energy has guaranteed UniSource Energy's obligations on the
Convertible Senior Notes.
On March 1, 2005, UniSource Energy used $106 million of the net proceeds
from the sale of the Convertible Senior Notes to repay its $95 million
promissory note to TEP plus accrued interest of $11 million. See Inter-Company
Notes Payable, below. TEP will use these funds to retire or repurchase $225
million of its outstanding debt obligations. See TEP Debt - Bond Repurchase and
Redemptions, below.
UNISOURCE CREDIT AGREEMENT
On April 15, 2005, UniSource Energy entered into a $105 million five-year
credit agreement with a group of lenders (UniSource Credit Agreement) which
expires on April 15, 2010. The UniSource Credit Agreement includes a $90 million
term loan facility and a $15 million revolving credit facility. In addition,
UniSource Energy is required to make quarterly payments of $1.25 million
beginning June 2005 with the balance due at maturity.
Interest is payable on borrowings under the UniSource Credit Agreement at a
Eurodollar rate or Alternate Base Rate rate. Eurodollar loans would bear
interest at adjusted LIBOR plus 1.75%. Alternate Base Rate loans would bear
interest in an amount equal to the sum of (1) the greater of the federal funds
rate plus 1/2 of 1% or the agent bank's reference rate, and (2) 0.75%. In the
event that, after June 30, 2005, TEP, because of regulatory restrictions, does
not have the ability to pay 100% of its current year net income as dividends,
interest rates would increase by 0.25%.
The UniSource Credit Agreement contains a number of covenants restricting
additional indebtedness, liens, mergers, sales of assets and investments and
acquisitions. Additionally, the UniSource Credit Agreement contains several
financial covenants including: (1) a minimum cash flow to interest coverage
ratio determined on a UniSource Energy standalone basis and (2) a maximum
leverage ratio determined on a consolidated basis. The UniSource Credit
Agreement allows UniSource Energy to pay dividends, if after giving effect to
the dividend payment, UniSource Energy and it subsidiaries have more than $15
million of unrestricted cash and unused revolving credit.
The UniSource Credit Agreement may become immediately payable if an event
of default occurs. An event of default includes failure to make required
payments under the UniSource Credit Agreement, failure of UniSource Energy or
certain subsidiaries to make payments or default on debt greater than $20
million, or certain bankruptcy events at UniSource Energy or certain
subsidiaries. The UniSource Credit Agreement is collateralized by a pledge of
the capital stock of Millennium, UES and UED.
INTER-COMPANY NOTES PAYABLE
In January 2005, UNS Gas established a short-term inter-company promissory
note to UniSource Energy, by allowing UNS Gas to borrow up to $10 million for
general corporate purposes. In March 2005, UniSource Energy contributed an
additional $6 million in equity to UNS Gas and an additional $4 million in
equity to UNS Electric, and UNS Gas repaid the $6 million outstanding on this
note from the proceeds of the $6 million equity contribution.
On January 1, 1998, TEP and UniSource Energy exchanged all the outstanding
common stock of TEP on a share-for-share basis for the Common Stock of UniSource
Energy in a transaction which resulted in UniSource Energy becoming a holding
company with TEP as its subsidiary. Following the share exchange, TEP
transferred the stock of Millennium to UniSource Energy for a $95 million
promissory note due in 2008. On March 1, 2005, UniSource Energy used $106
million of the $146 million of net proceeds from the convertible debt offering,
see above, to repay the $95 million promissory note to TEP plus accrued interest
of $11 million. Approximately $25 million of this note represented a gain to
15
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
TEP. TEP did not record this gain in income. Instead, this gain was reflected as
an increase in TEP's common stock equity when UniSource Energy repaid the note.
TEP DEBT
BOND REPURCHASE AND REDEMPTIONS
TEP made the required sinking fund payment of $1 million on its 6.1% First
Mortgage IDBs in January 2005. In March 2005, TEP redeemed at par the remaining
$31 million of its 6.1% First Mortgage IDBs, which were due in 2008, as well as
the remaining $21 million of its 7.5% First Mortgage IDBs, which were due in
2006.
As stated in a recently expired tender offer, TEP has agreed to purchase
$147 million of its 1997 Pima Series B and $74 million of its 1997 Pima Series C
fixed-rate tax-exempt debt obligations (Repurchased Bonds) from bondholders on
May 11, 2005, at a price of $101.50 per $100 principal amount. Additionally, TEP
will redeem at par $4 million of bonds not tendered on May 18, 2005. TEP does
not plan on canceling the Repurchased Bonds. The Repurchased Bonds will remain
outstanding under their respective indentures; however, the Repurchased Bonds
will not be presented in our financial statements. TEP may choose to cancel or
resell the Repurchased Bonds to third parties in the future.
TEP CREDIT AGREEMENT
On May 4, 2005, TEP entered into a new $401 million Credit Agreement (TEP
Credit Agreement) to replace its previous $401 million credit agreement. The TEP
Credit Agreement includes a $60 million revolving credit facility and a $341
million letter of credit facility to support $329 million aggregate principal
amount of tax-exempt variable rate bonds. The TEP Credit Agreement expires May
4, 2010 and is secured by $401 million of Second Mortgage Bonds.
Covenants in the TEP Credit Agreement restrict additional indebtedness,
liens and sale of assets and sale-leasebacks agreements. The TEP Credit
Agreement also contains several financial covenants including: (1) a minimum
cash coverage ratio, and (2) a maximum leverage ratio. If TEP complies with the
terms of the TEP Credit Agreement, TEP may pay dividends to UniSource Energy.
Certain regulatory actions may cause a decrease in the amount that may be
borrowed.
The TEP Credit Agreement may become immediately due and payable if an event
of default occurs. An event of default includes failure to make required
payments under the TEP Credit Agreement; change in control, as defined; failure
of TEP or certain subsidiaries to make payments or default on debt greater than
$20 million; or certain bankruptcy events at TEP.
Interest rates and fees under the TEP Credit Agreement are based on a
pricing grid tied to TEP's credit ratings. The letter of credit fees are 0.875%
under the TEP Credit Agreement. Amounts drawn under the letter of credit would
currently bear interest based on LIBOR plus 0.875% per annum. Borrowings under
the revolving credit facility bear interest at a variable interest consisting of
a spread over LIBOR or an alternate base rate. The per annum rate currently in
effect on borrowings under TEP's revolving credit facility is LIBOR plus 0.875%.
TEP also pays a commitment fee of 0.20% on the unused portion of the revolving
credit facility.
At May 6, 2005, TEP had no outstanding borrowings under the revolving
credit facility component of the TEP Credit Agreement.
UNS GAS/UNS ELECTRIC REVOLVER
On April 15, 2005, UNS Gas and UNS Electric, each as a borrower, and UES,
as guarantor, entered into a $40 million three-year unsecured revolving credit
agreement with a group of lenders (the UNS Gas/UNS Electric Revolver). Either
borrower may borrow up to a maximum of $30 million; however, the total combined
amount borrowed can not exceed $40 million. The UNS Gas/UNS Electric Revolver
expires on April 15, 2008.
UNS Gas is only liable for UNS Gas' borrowings, and similarly, UNS Electric
is only liable for UNS Electric's borrowings under the UNS Gas/UNS Electric
Revolver. UES guarantees the obligations of both UNS Gas and UNS Electric.
16
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
Interest is payable at LIBOR plus 1.50%; or at a rate equal to the sum of:
(1) the greater of the federal funds rate plus 1/2 of 1% or a bank reference
rate, and (2) 0.50%.
The UNS Gas/UNS Electric Revolver contains a number of covenants which
restrict additional indebtedness, liens, mergers and sales of assets. The UNS
Gas/UNS Electric Revolver also contains several financial covenants including:
(1) a maximum consolidated leverage ratio and (2) a minimum cash flow to
interest coverage ratio, in each case determined for each borrower on a
standalone basis.
The UNS Gas/UNS Electric Revolver may become immediately due and payable if
an event of default occurs. An event of default includes failure to make
required payments under the UNS Gas/UNS Electric Revolver; a change in control,
as defined, or certain bankruptcy events of UNS Gas or UNS Electric; or failure
of UES, UNS Gas or UNS Electric to make payments or default on debt greater than
$4 million.
NOTE 4. BUSINESS SEGMENTS
--------------------------
Based on the way we organize our operations and evaluate performance, we
have four reportable segments:
(1) TEP, a vertically integrated electric utility business, is UniSource
Energy's largest subsidiary.
(2) UNS Gas is a regulated gas distribution business.
(3) UNS Electric is a regulated electric distribution utility business.
(4) Global Solar, a developer and manufacturer of light-weight thin-film
photovoltaic cells and panels, is the largest investment held by
Millennium.
The UniSource Energy, UES and Millennium holding companies, UED, and
several other subsidiaries and equity investments, which are not considered
reportable segments, are included in All Other. Through affiliates, Millennium
holds investments in several unregulated energy and emerging technology
companies. UED, a wholly-owned subsidiary of UniSource Energy, developed
generating resources and performed other project development activities,
including the expansion of the Springerville Generating Station.
Our reportable segments have changed from the segments reported in prior
years. We have reclassified information for earlier periods to conform to the
current year's presentation.
Significant reconciling adjustments consist of the elimination of
inter-company activity and balances. Other Millennium subsidiaries recorded
revenue from transactions with TEP of $3 million during each of the three-month
periods ended March 31, 2005 and March 31, 2004. TEP's related expense is
reported in Other Operations and Maintenance expense on its income statement.
Millennium's revenue and TEP's related expense are eliminated in UniSource
Energy consolidation. Other significant reconciling adjustments include the
elimination of investments in subsidiaries held by UniSource Energy, the
inter-company note between UniSource Energy and TEP, the related interest income
and expense on the note and reclassifications of deferred tax assets and
liabilities. The inter-company note between UniSource Energy and TEP was repaid
on March 1, 2005. See Note 3.
We record our percentage share of the earnings of affiliated companies when
we hold a 20% to 50% voting interest, except for investments where we provide
all of the financing, in which case we recognize 100% of the losses.
17
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
We disclose selected financial data for our reportable segments in the
following table:
REPORTABLE SEGMENTS
----------------------------------------- UNISOURCE
UNS UNS GLOBAL ALL RECONCILING ENERGY
TEP GAS ELECTRIC SOLAR OTHER ADJUSTMENTS CONSOLIDATED
------------------------------------------------------------------------------------------------------------------------------------
INCOME STATEMENT -Millions of Dollars-
------------------------------------------------------------------------------------------------------------------------------------
THREE MONTHS ENDED MARCH 31, 2005:
------------------------------------------------------------------------------------------------------------------------------------
Operating Revenues - External $ 181 $ 47 $ 32 $ - $ 1 $ - $ 261
------------------------------------------------------------------------------------------------------------------------------------
Operating Revenues - Intersegment 1 - - - 3 (4) -
------------------------------------------------------------------------------------------------------------------------------------
Income (Loss) Before Income Taxes (7) 7 1 (3) (3) - (5)
------------------------------------------------------------------------------------------------------------------------------------
Net Income (Loss) (5) 4 1 (2) (2) - (4)
------------------------------------------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------------------------------------------
THREE MONTHS ENDED MARCH 31, 2004:
Operating Revenues - External $ 187 $ 49 $ 31 $ 1 $ 2 $ - $ 270
------------------------------------------------------------------------------------------------------------------------------------
Operating Revenues - Intersegment - - - - 3 (3) -
------------------------------------------------------------------------------------------------------------------------------------
Income (Loss) Before Income Taxes 3 7 1 (2) 3 - 12
------------------------------------------------------------------------------------------------------------------------------------
Net Income (Loss) 1 4 1 (1) 1 - 6
------------------------------------------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------------------------------------------
BALANCE SHEET
------------------------------------------------------------------------------------------------------------------------------------
Total Assets, March 31, 2005 $ 2,629 $ 204 $ 139 $ 21 $ 843 $ (683) $ 3,153
------------------------------------------------------------------------------------------------------------------------------------
Total Assets, December 31, 2004 2,742 201 135 21 930 (853) 3,176
------------------------------------------------------------------------------------------------------------------------------------
NOTE 5. ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND TRADING ACTIVITIES
---------------------------------------------------------------------
TEP enters into forward contracts to purchase or sell a specified amount of
capacity or energy at a specified price over a given period of time, typically
for one month, three months, or one year, within established limits to take
advantage of favorable market opportunities. In general, TEP enters into forward
purchase contracts when market conditions provide the opportunity to purchase
energy for its load at prices that are below the marginal cost of its supply
resources or to supplement its own resources (e.g., during plant outages and
summer peaking periods). TEP enters into forward sales contracts when it
forecasts that it has excess supply and the market price of energy exceeds its
marginal cost. The majority of TEP's forward contracts are considered to be
normal purchases and sales and, therefore, are not required to be marked to
market. However, some of these forward contracts are considered to be
derivatives, which TEP marks to market by recording unrealized gains and losses
and adjusting the related assets and liabilities on a monthly basis to reflect
the market prices at the end of the month.
TEP has a natural gas supply agreement under which it purchases all of its
gas requirements at spot market prices from Southwest Gas Corporation (SWG). TEP
also has agreements to purchase power that are priced using spot market gas
prices. These contracts meet the definition of normal purchases and are not
required to be marked to market. During 2004 and early 2005, in an effort to
minimize price risk on these purchases, TEP entered into commodity price swap
agreements under which TEP purchases gas at fixed prices and simultaneously
sells gas at spot market prices. The spot market price in the swap agreements is
tied to the same index as the purchases under the SWG and purchased power
contracts. These swap agreements, which expire during the summer months through
2007, were entered into with the goal of locking in fixed prices on at least 45%
and not more than 80% of TEP's expected summer monthly gas risk prior to
entering into the month. TEP's swap agreements are marked to market on a monthly
basis; however, since the agreements satisfy the requirements for cash flow
hedge accounting, the unrealized gains and losses are recorded in Other
Comprehensive Income, a component of Common Stock Equity, rather than being
reflected in the income statement. As the gains and losses on these cash flow
hedges are realized, a reclassification adjustment is recorded in Other
Comprehensive Income for realized gains and losses that are included in Net
Income.
TEP manages the risk of counterparty default by performing financial credit
reviews, setting limits, monitoring exposures, requiring collateral when needed,
and using a standardized agreement which allows for the netting of current
period exposures to and from a single counterparty.
UNS Gas and UNS Electric do not currently have any contracts that are
required to be marked to market. UNS Gas does have a natural gas supply and
management agreement under which it purchases substantially all of its gas
18
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
requirements at market prices from BP Energy Company (BP). However, the contract
terms allow UNS Gas to lock in fixed prices on a portion of its gas purchases by
entering into fixed price forward contracts with BP at various times during the
year. This enables UNS Gas to provide more stable prices to its customers. These
purchases are made up to three years in advance with the goal of locking in
fixed prices on at least 45% and not more than 80% of the expected monthly gas
consumption prior to entering into the month. These forward contracts, as well
as the main gas supply contract, meet the definition of normal purchases and
therefore are not required to be marked to market.
Millenium Environmental Group, Inc. (MEG), a wholly-owned subsidiary of
Millennium, enters into swap agreements, options and forward contracts relating
to Emissions Allowances and coal. MEG marks its trading contracts to market by
recording unrealized gains and losses and adjusting the related assets and
liabilities on a monthly basis to reflect the market prices at the end of the
month.
The market prices used to determine fair values for TEP and MEG's
derivative instruments are estimated based on various factors including broker
quotes, exchange prices, over the counter prices and time value.
TEP and MEG's derivative activities are reported as follows:
INCOME STATEMENT LINE
------------------------------------------------------------------------
NET UNREALIZED GAINS NET REALIZED GAINS
AND LOSSES AND LOSSES
---------------------------------------------------------------------------------------------------------------------
TEP Forward Sales Contracts Electric Wholesale Sales Electric Wholesale Sales
TEP Forward Purchase Contracts Purchased Power Purchased Power
TEP Commodity Price Swaps Other Comprehensive Income Fuel Expense
(Balance Sheet)
MEG Trading Activities Other Operating Revenues Other Operating Revenues
---------------------------------------------------------------------------------------------------------------------
Although MEG's realized gains and losses on trading activities are reported
net on UniSource Energy's income statement, the related cash receipts and cash
payments are reported separately on UniSource Energy's statement of cash flows.
The net pre-tax gains and losses from TEP and MEG's derivative activities
were as follows:
Three Months Ended
March 31,
-----------------------------------
2005 2004
---------------------------------------------------------------------------------------------------------------------
-Millions of Dollars-
TEP:
Net Unrealized (Loss) Gain on Forward Sales Contracts $ (0.8) $ 0.5
Net Unrealized Gain (Loss) on Forward Purchase Contracts 1.2 (0.3)
Net Unrealized Gain on Commodity Price Swaps 5.7 1.5
Net Realized Gain on Commodity Price Swaps 0.1 -
MEG:
Net Gain from Trading Activities 0.3 0.2
---------------------------------------------------------------------------- ------------------ ----------------
TEP and MEG's derivative assets and liabilities are reported as follows:
BALANCE SHEET LINE
-----------------------------------------------------
ASSETS LIABILITIES
---------------------------------------------------------------------------------------------------------------------
TEP - Current Other Current Assets Other Current Liabilities
TEP - Noncurrent Other Assets Other Liabilities
MEG - Current (including Emissions Allowance Inventory) Trading Assets Trading Liabilities
MEG - Noncurrent Other Assets Other Liabilities
---------------------------------------------------------------------------------------------------------------------
19
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
The fair value of TEP and MEG's derivative assets and liabilities were as
follows:
March 31, December 31,
2005 2004
--------------------------------------------------------------------------------
-Millions of Dollars-
TEP:
Derivative Assets - Current $ 5.7 $ 2.3
Derivative Assets - Noncurrent 4.2 1.3
Derivative Liabilities - Current - (0.1)
MEG:
Trading Assets - Current 50.8 71.0
Trading Assets - Noncurrent 5.6 5.5
Trading Liabilities - Current (51.0) (65.0)
--------------------------------------------------------------------------------
Beginning January 1, 2004, the settlement of forward purchase and sales
contracts that do not result in physical delivery are recorded net as a
component of Electric Wholesale Sales in TEP's income statement. For the three
months ended March 31, 2005, $5 million in sales were netted against $4 million
in purchases and for the three months ended March 31, 2004, $1 million in sales
were netted against $1 million in purchases.
In accordance with UniSource Energy's intention to cease making capital
contributions to Millennium, Millennium has significantly reduced the holdings
and activity of MEG. MEG is in the process of winding down its activities and
will not engage in any new activities after 2005.
NOTE 6. COMMITMENTS AND CONTINGENCIES
--------------------------------------
TEP CONTINGENCIES
SPRINGERVILLE GENERATING STATION COMPLAINT
Environmental activist groups have expressed concerns regarding the
construction of any new units at the Springerville Generating Station. In
January 2003, environmental activist groups appealed an ACC Order affirming the
ACC's approval of the expansion at the Springerville Generating Station to the
Superior Court of the State of Arizona. On October 22, 2003, the Superior Court
affirmed the ACC's issuance of the Certificate of Environmental Compatibility
for Springerville Generating Station. The environmental activist groups appealed
the Superior Court decision on December 30, 2003 and filed an amended notice of
appeal on January 2, 2004 with the Arizona Court of Appeals. In February 2005,
the Arizona Court of Appeals upheld the lower court's ruling affirming the ACC's
approval of the expansion at Springerville Generating Station. The Grand Canyon
Trust (GCT), one of the environmental activist groups with this appeal, agreed
to resolve this claim against TEP. The other environmental activist group
petitioned the Arizona Supreme Court for review on March 24, 2005.
LITIGATION AND CLAIMS RELATED TO SAN JUAN GENERATING STATION
The Environmental Protection Agency (EPA) has listed San Juan as a
potential damage case pursuant to the Resource Conservation and Recovery Act due
to claims by third parties that the San Juan Generating Station has contaminated
water resources in the region as a result of disposing of fly ash in the surface
mine pits adjacent to the generating station. Public Service Company of New
Mexico (PNM), operator of San Juan, and the coal supplier to San Juan vigorously
deny these allegations. In November 2004, a contractor for the EPA determined
that any contamination at San Juan cannot be conclusively attributed to the
disposal of fly ash, however, the EPA has not made a final determination. TEP
owns 50% of San Juan Units 1 and 2, which equates to 19.8% of the total San Juan
Generating Station. TEP does not believe that this issue will have a material
adverse impact on TEP or its operations.
LITIGATION AND CLAIMS RELATED TO NAVAJO GENERATING STATION
On October 15, 2004, Peabody Western Coal Company (Peabody), the coal
supplier to the Navajo Generating Station, filed a complaint in the Circuit
Court for the City of St. Louis, Missouri against the participants at Navajo,
including TEP, for reimbursement of royalties and other costs and breach of the
coal supply agreement. The case was removed to Federal District Court Eastern
District of Missouri on February 10, 2005. Peabody subsequently filed a motion
20
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
to remand to superior court. Because TEP owns 7.5% of the Navajo Generating
Station, its share of the current claimed damages would be approximately $35
million. TEP believes these claims are without merit and intends to continue to
contest them.
POSTRETIREMENT AND PENSION BENEFIT COSTS AT NAVAJO GENERATING STATION
Peabody has filed a lawsuit against the participants at Navajo Generating
Station, including TEP, for postretirement benefit costs payable to the coal
supplier's employees under the coal supply agreements. The Navajo participants
and Peabody have agreed to stay the discovery process in this litigation until
August 31, 2005 to allow the parties additional time to negotiate a potential
settlement. To the extent that amounts become estimable and payment probable,
TEP will record a liability for additional postretirement benefit costs at the
Navajo Generating Station. TEP does not expect any settlement to be material to
TEP.
TEP has previously settled claims for postretirement benefit costs with the
coal suppliers at Springerville Generating Station and Four Corners Generating
Station. The cost of postretirement benefits is included in the cost of coal to
San Juan.
ENVIRONMENTAL RECLAMATION AT REMOTE GENERATING STATIONS
TEP currently pays on-going reclamation costs related to the coal mines
which supply the remote generating stations, and it is probable that TEP will
have to pay a portion of final reclamation costs upon mine closure. When a
reasonable estimate of final reclamation costs is available, the liability is
recognized as a cost of coal over the remaining term of the respective coal
supply agreement. At March 31, 2005, TEP estimates its undiscounted final
reclamation liability to be $42 million, and the present value of TEP's
liability for final reclamation approximates $12 million at the expiration dates
of the coal supply agreements.
Amounts recorded for final reclamation are subject to various assumptions
and determinations, such as estimating the costs of reclamation, estimating when
final reclamation will occur, and the credit-adjusted risk-free interest rate to
be used to discount future liabilities. Changes that may arise over time with
regard to these assumptions and determinations will change amounts recorded in
the future as expense for post-term reclamation. TEP does not believe that
recognition of its final reclamation obligations will be material to TEP in any
single year since recognition occurs over the remaining lives of its coal supply
agreements.
MILLENNIUM CONTINGENCY - NATIONS ENERGY
In September 2001, Nations Energy sold its 26% equity interest in a power
project located in Curacao, Netherlands Antilles to Mirant Curacao Investments,
Ltd. (Mirant Curacao) a subsidiary of Mirant Corporation (Mirant). Nations
Energy received $5 million in cash and an $11 million note receivable from
Mirant Curacao. The note was recorded at its net present value of $8 million
using an 8% discount rate, the discount being recognized as interest income over
the five-year life of the note. As of March 31, 2005, Nations Energy's
receivable from Mirant Curacao is approximately $8 million. The note is
primarily included in Investments and Other Property - Other on UniSource
Energy's balance sheet. The first payment of $2 million on the receivable was
received in June 2004. The remaining payments on the note receivable are
expected to be received as follows: $4 million in July 2005 and $5 million in
July 2006.
The note is guaranteed by Mirant Americas, Inc., a subsidiary of Mirant. On
July 14, 2003, Mirant, Mirant Americas, Inc. and various other Mirant companies
filed for Chapter 11 bankruptcy protection. Mirant Curacao was not included in
the Chapter 11 filings. Based on a review of the projected cash flows for the
power project, it appears Mirant Curacao will have sufficient future cash flows
to pay the note receivable and any applicable interest. However, we cannot
predict the ultimate outcome that Mirant's bankruptcy will have on the
collectibility of the note from Mirant Curacao. Nations Energy will continue to
evaluate the collectibility of the receivable, but currently expects to collect
the note in its entirety and has not recorded any reserve for this note.
MILLENNIUM COMMITMENT
In April 2005, Millennium committed to fund $3 million to an investment of
Infinite Power Solutions, Inc. (IPS).
21
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
GUARANTEES AND INDEMNITIES
In the normal course of business, UniSource Energy and certain subsidiaries
enter into various agreements providing financial or performance assurance to
third parties on behalf of certain subsidiaries. We enter into these agreements
primarily to support or enhance the creditworthiness of a subsidiary on a
stand-alone basis. The most significant of these guarantees are:
o UES' guarantee of $160 million of aggregate principal amount of senior
unsecured notes issued by UNS Gas and UNS Electric to purchase the
Citizens Arizona gas and electric utility assets,
o UES' guarantee of a $40 million unsecured revolving credit agreement
for UNS Gas and UNS Electric,
o UniSource Energy's guarantee of approximately $8 million in natural
gas transportation and supply payments in addition to building and
equipment lease payments for UNS Gas, UNS Electric, and subsidiaries
of Millennium, and
o Millennium's guarantee of approximately $3 million in
commodity-related payments for MEG and building lease payments for a
subsidiary.
In addition, UniSource Energy and its subsidiaries have indemnified the
purchasers of interests in certain investments from additional taxes due for
years prior to the sale of such investments. The terms of the indemnifications
provide for no limitation on potential future payments; however, we believe that
we have abided by all tax laws and paid all tax obligations. We have not made
any payments under the terms of these indemnifications to date.
We believe that the likelihood UniSource Energy, UES, or Millennium would
be required to perform or otherwise incur any significant losses associated with
any of these guarantees or indemnities is remote.
NOTE 7. TEP WHOLESALE ACCOUNTS RECEIVABLE AND ALLOWANCES
---------------------------------------------------------
TEP's Accounts Receivable from Electric Wholesale Sales, included in Trade
Accounts Receivable on the balance sheet, totaled $21 million at March 31, 2005
and $22 million at December 31, 2004, net of allowances. TEP's Allowance for
Doubtful Accounts on the balance sheet includes $13 million at March 31, 2005
and $13 million at December 31, 2004 related to sales to the California Power
Exchange (CPX) and the California Independent System Operator (CISO) in 2001 and
2000. Excluding the receivables from the CPX and the CISO, substantially all of
the December 31, 2004 wholesale receivable balance has been collected as of the
date of this filing.
TEP's collection shortfall from the CPX and the CISO was approximately $9
million for sales made in 2000 and $7 million for sales made in 2001. Since that
time, the FERC staff has proposed various methodologies for calculating amounts
of refunds/offsets applicable to wholesale sales made into the CISO's spot
markets from October 2000 to June 2001. Based upon a FERC order in March 2003
(as reaffirmed by the FERC on October 16, 2003), TEP estimated that it would
receive approximately $6 million of its $16 million receivable. In May 2004, the
FERC issued two separate orders addressing numerous issues in the refund
calculation and the fuel cost allowance calculation (an offset to the refund
obligation). Based on these new orders, TEP increased its reserve for sales to
the CPX and the CISO by $3 million by recording a reduction of wholesale
revenues.
There are several other outstanding legal issues, complaints and lawsuits
concerning the California energy crisis related to the FERC, wholesale power
suppliers, Southern California Edison Company, Pacific Gas and Electric Company,
the CPX and the CISO. We cannot predict the outcome of these issues or lawsuits.
We believe, however, that TEP is adequately reserved for its transactions with
the CPX and the CISO.
NOTE 8. UNISOURCE ENERGY EARNINGS PER SHARE (EPS)
--------------------------------------------------
Basic EPS is computed by dividing net income (loss) by the weighted average
number of common shares outstanding during the period. Except when the effect
would be anti-dilutive, the diluted EPS calculation includes the impact of
shares that could be issued upon exercise of outstanding stock options,
contingently issuable shares under equity-based awards or common shares that
would result from the conversion of convertible notes. The numerator in
22
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
calculating diluted earnings per share is net income (loss) adjusted for the
interest on convertible notes (net of tax) that would not be paid if the notes
were converted to common shares.
The following table shows the effects of potential dilutive common stock on
the weighted average number of shares:
Three Months Ended
March 31,
2005 2004
--------------------------------------------------------------------------------
- In Thousands -
Denominator:
Weighted-average Shares of Common Stock Outstanding 34,635 34,185
Effect of Dilutive Securities:
Convertible Senior Notes - -
Options and Stock Issuable under Employee Benefit Plans
and the Directors' Plan - 703
--------------------------------------------------------------------------------
Total Shares 34,635 34,888
================================================================================
Due to UniSource Energy's net loss for the quarter ended March 31, 2005,
the following potential shares of common stock were excluded from the diluted
EPS calculation because the effect would be anti-dilutive:
o 1,377,780 shares: the $150 million aggregate principal amount of
convertible notes issued on March 1, 2005 and convertible into
1,377,780 shares (weighted for the number of days outstanding in the
period) at a conversion price of approximately $37.50 per share.
o 746,937 incremental common shares related to options and contingently
issuable shares.
There were no antidilutive options excluded as of March 31, 2004.
NOTE 9. EMPLOYEE BENEFITS PLANS
--------------------------------
PENSION BENEFIT PLANS
TEP and UES maintain noncontributory, defined benefit pension plans for
substantially all regular employees and certain affiliate employees. Benefits
are based on years of service and the employee's average compensation. TEP and
UES fund the plans by contributing at least the minimum amount required under
Internal Revenue Service regulations. Additionally, we provide supplemental
retirement benefits to certain employees whose benefits are limited by Internal
Revenue Service benefit or compensation limitations.
OTHER POSTRETIREMENT BENEFIT PLANS
TEP provides limited health care and life insurance benefits for retirees.
All regular employees may become eligible for these benefits if they reach
retirement age while working for TEP or an affiliate. UES provides
postretirement medical benefits for current retirees and a small group of active
employees. The majority of UES employees do not participate in the
postretirement medical plan.
The ACC allows TEP and UES to recover postretirement costs through rates
only as benefit payments are made to or on behalf of retirees. The
postretirement benefits are currently funded entirely on a pay-as-you-go basis.
Under current accounting guidance, TEP and UES cannot record a regulatory asset
for the excess of expense calculated per Statement of Financial Accounting
Standards No. 106, Employers' Accounting for Postretirement Benefits Other Than
Pensions, over actual benefit payments.
23
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
COMPONENTS OF NET PERIODIC BENEFIT COST
The components of net periodic benefit costs are as follows:
OTHER POSTRETIREMENT
PENSION BENEFITS BENEFITS
--------------------------------------------------------
Three Months Ended Three Months Ended
March 31, March 31,
2005 2004 2005 2004
-------------------------------------------------------------------------------------------------------------
-Millions of Dollars -
COMPONENTS OF NET PERIODIC BENEFIT COST
Service Cost $ 1.7 $ 1.5 $ 0.5 $ 0.5
Interest Cost 2.8 2.4 1.0 0.9
Expected Return on Plan Assets (2.9) (2.7) - -
Prior Service Cost Amortization 0.5 0.5 (0.3) (0.4)
Recognized Actuarial (Gain) Loss 0.7 0.4 0.5 0.5
-------------------------------------------------------------------------------------------------------------
NET PERIODIC BENEFIT COST $ 2.8 $ 2.1 $ 1.7 $ 1.5
=============================================================================================================
NOTE 10. SHARE-BASED COMPENSATION PLANS
----------------------------------------
UniSource Energy has issued equity-based compensation awards under the
Directors' Plan and the Omnibus Plan. After February 4, 2004, no new awards can
be granted under the Omnibus Plan. Effective January 1, 2005, we early adopted
the accounting for our share-based plans. Prior to January 1, 2005, we accounted
for those plans under the recognition and measurement principles of APB 25. See
Note 1.
At March 31, 2004, we had stock options, stock units and restricted stock
grants outstanding as discussed below.
STOCK OPTIONS
There were no stock options granted under the Directors' Plan during the
three-month period ended March 31, 2005. Also, there were no stock options
granted under the Omnibus Plan or the Directors' Plan during the three-month
period ended March 31, 2004. Director stock option awards currently vest over
three years, become exercisable in one-third increments on each anniversary date
of the grant and expire on the tenth anniversary of the grant.
A summary of the stock option activity of the Directors' Plan and Omnibus
Plan is as follows:
Three Months Ended March 31,
2005 2004
--------------------------------------------------------------------------------------------------------
WEIGHTED Weighted
AVERAGE Average
EXERCISE Exercise
SHARES PRICE Shares Price
--------------------------------------------------------------------------------------------------------
Options Outstanding,
Beginning of Period 2,076,055 $ 16.19 2,478,551 $ 16.04
Granted - - - -
Exercised (212,279) $ 16.44 (203,791) $ 14.90
Forfeited (483) $ 12.28 (1,134) $ 13.85
----------------- ----------------
Options Outstanding,
End of Period 1,863,293 $ 16.16 2,273,626 $ 16.15
================= ================
Options Exercisable,
End of Period 1,855,402 $ 16.16 2,249,624 $ 16.13
Weighted Average Remaining Contractual Life at March 31, 2005: 5.42 years
--------------------------------------------------------------------------------------------------------
24
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
Stock options awarded on January 1, 2002 accrue dividend equivalents that
are paid in cash on the earlier of the date of exercise of the underlying option
or the date the option expires. Compensation expense is recognized as dividends
are declared. In the first quarter of 2005 and 2004, we recognized compensation
expense of less than $0.1 million for dividend equivalents on stock option
grants.
RESTRICTED STOCK AND STOCK UNITS
In the first quarter of 2005 and 2004, we granted restricted stock awards
to directors totaling 6,528 shares and 6,480 shares, respectively. The grant
date fair value of the shares was $24.51 per share in 2005 and $24.68 per share
in 2004. Directors may elect to receive stock units in lieu of restricted
shares. The restricted shares or stock units become 100% vested on the third
anniversary of the grant date. Compensation expense equal to the fair market
value on the date of the award is recognized over the vesting period. We
recorded compensation expense of less than $0.1 million in the first quarter of
2005 and 2004 related to these awards.
There were no new stock unit awards granted under the Omnibus Plan in the
first quarter of 2005 or 2004. When awards are granted, compensation expense
equal to the fair market value on the date of the award is recognized over a
three or four year vesting period. All stock unit awards under the Omnibus Plan
had fully vested as of March 6, 2004. We recognized compensation expense related
to earlier awards of less than $0.1 million in the first quarter of 2004.
Fully vested but undistributed stock unit awards accrue dividend equivalent
stock units based on the fair market value of common shares on the date the
dividend is paid. Compensation expense is recognized when dividends are
declared. We recorded compensation expense of less than $0.1 million in the
first quarter of 2005 and 2004 for dividend equivalent stock units.
PERFORMANCE SHARES
In May 2003, the Board of Directors approved a grant of performance shares
to key employees under the Omnibus Plan. The shares were to be awarded at the
end of a three-year performance period based on goal attainment. The grant date
fair value was $17.84 per share. Compensation expense was initially recorded
over the performance period based on the anticipated number and market value of
shares to be awarded. As a result of the shareholder vote to approve the
proposed merger, 53,566 performance shares vested and were distributed in March,
2004. See the 2004 Annual Report on Form 10-K, Note 17 of Notes to Consolidated
Financial Statements - Stock-Based Compensation Plans. Compensation expense of
$2 million was recorded in the first quarter of 2004 for this award.
NOTE 11. INCOME AND OTHER TAXES
--------------------------------
INCOME TAXES
The differences between the income tax expense (benefit) and the amount
obtained by multiplying pre-tax income (loss) by the U.S. statutory federal
income tax rate of 35% are as follows:
UNISOURCE ENERGY TEP
---------------------------------------------------------
Three Months Ended Three Months Ended
March 31, March 31,
2005 2004 2005 2004
------------------------------------------------------------------------------------------------------------------------------------
-Thousands of Dollars -
FEDERAL INCOME TAX EXPENSE (BENEFIT) AT STATUTORY RATE $ (1,858) $ 4,316 $ (2,398) $ 1,004
State Income Tax Expense (Benefit), Net of Federal Deduction (244) 566 (315) 130
Depreciation Differences (Flow Through Basis) 680 789 680 789
Tax Credits (131) (129) (131) (129)
Other 27 367 2 280
------------------------------------------------------------------------------------------------------------------------------------
TOTAL FEDERAL AND STATE INCOME TAX EXPENSE (BENEFIT) $ (1,526) $ 5,909 $ (2,162) $ 2,074
====================================================================================================================================
25
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
The total Federal and State Income Tax Expense (Benefit) in the table above
is included in UniSource Energy and TEP's income statements.
OTHER TAXES
TEP and UES act as conduits or collection agents for excise tax (sales tax)
as well as franchise fees and regulatory assessments. They record liabilities
payable to governmental agencies when they bill their customers for these
amounts. Neither the amounts billed nor payable are reflected in the income
statement.
NOTE 12. NEW ACCOUNTING PRONOUNCEMENTS
---------------------------------------
The FASB recently issued the following Statements of Financial Accounting
Standards (FAS), FASB Interpretations (FIN), and FASB Staff Positions (FSP):
o FIN 47, Accounting for Conditional Asset Retirement Obligations,
issued March 2005, provides guidance for a legal obligation to perform
an asset retirement activity in which the timing and (or) method of
settlement are conditional on a future event that may or may not be
within the control of the entity. The obligation to perform the asset
retirement activity is unconditional even though uncertainty exists
about the timing and (or) method of settlement. FIN 47 requires a
liability be recognized for the fair value of a conditional asset
retirement obligation if the fair value can be reasonably estimated.
FIN 47 is required to be applied by December 31, 2005. We are
evaluating the impact on our financial position and results of
operations of the adoption of FIN 47.
o FSP FIN 46(R)-5, Implicit Variable Interests under FASB Interpretation
No. 46 (revised December 2003), Consolidation of Variable Interest
Entities, issued March 2005, addresses whether a reporting enterprise
should consider whether it holds an implicit variable interest in a
variable interest entity (VIE) or potential VIE when specific
conditions exist. The guidance in FSP FIN 46(R)-5 was effective April
1, 2005, and did not have a significant impact on our financial
statements.
o FAS 153, Exchanges of Nonmonetary Assets, issued December 2004,
requires nonmonetary exchanges be accounted for at fair value,
recognizing any gains or losses, if their fair value is determinable
within reasonable limits and the transaction has commercial substance.
A nonmonetary exchange has commercial substance if future cash flows
of the entity are expected to change significantly as a result of the
exchange. FAS 153 is effective for nonmonetary asset exchange
transactions occurring in fiscal periods beginning after June 15,
2005. The adoption of FAS 153 is not expected to have a significant
impact on our financial statements.
o FSP FAS 109-1, Application of FASB Statement No. 109, Accounting for
Income Taxes, to the Tax Deduction on Qualified Production Activities
Provided by the American Jobs Creation Act of 2004, issued in December
2004, provides guidance on the application of FAS 109 to the provision
within the American Jobs Creation Act of 2004 that provides a tax
deduction, beginning in 2005, on qualified production activities,
including a company's electric generation activities. Under FSP FAS
109-1, recognition of the tax deduction on qualified production
activities is ordinarily reported in the year it is earned. FSP FAS
109-1 did not have a significant impact on our financial statements in
the first quarter. We are evaluating the impact of FSP FAS 109-1 on
our financial position and results of operations for the remainder of
the year.
o FAS 151, Inventory Costs, issued November 2004, is an amendment of
Accounting Research Bulletin (ARB) No. 43, Chapter 4, Inventory
Pricing. FAS 151 clarifies that abnormal amounts of idle facility
expense, freight, handling costs, and wasted materials (spoilage)
should be recognized as current-period charges. FAS 151 also requires
the allocation of fixed production overheads to inventory based on the
normal capacity of the production facilities. FAS 151 is effective for
inventory costs incurred during fiscal years beginning after June 15,
2005. The adoption of FAS 151 is not expected to have a significant
impact on our financial statements.
In June 2004, the EITF published Issue No. 03-1, The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain Investments (EITF
03-1). EITF 03-1 provides application guidance on impairment of securities
accounted for under FAS 115, Accounting for Certain Investments in Debt and
Equity Securities, and cost method investments and requires certain quantitative
and qualitative disclosures for securities that are impaired at the balance
sheet date but for which an other-than-temporary impairment has not been
recognized. The disclosure requirements are effective for reporting periods
ending after December 31, 2003. The FASB issued FSP EITF Issue 03-1-1, Effective
Date of Paragraphs 10-20 of EITF Issue No. 03-1, The Meaning of
26
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
--------------------------------------------------------------------------------
Other-Than-Temporary Impairment and Its Application to Certain Investments in
September 2004 delaying the effective date of the application guidance on
impairment of securities until the final issuance of FSP EITF Issue 03-1-a. As
of May 6, 2005, a final FSP EITF Issue 03-1-a has not been issued. The adoption
of EITF 03-1 is not expected to have a significant impact on our financial
statements.
NOTE 13. SUPPLEMENTAL CASH FLOW INFORMATION
--------------------------------------------
A reconciliation of net income to net cash flows from operating activities
follows:
UNISOURCE ENERGY
--------------------------------
Three Months Ended
March 31,
2005 2004
-------------------------------------------------------------------------------------------------------------------------
-Thousands of Dollars-
NET INCOME $ (3,783) $ 6,421
ADJUSTMENTS TO RECONCILE NET INCOME
TO NET CASH FLOWS
Depreciation and Amortization Expense 34,824 35,136
Depreciation Recorded to Fuel and Other O&M Expense 1,570 1,556
Amortization of Transition Recovery Asset 9,487 8,597
Net Unrealized Gain on TEP Forward Electric Sales 817 (509)
Net Unrealized Loss on TEP Forward Electric Purchases (1,151) 327
Net Unrealized Gain on MEG Trading Activities 2,203 (1,584)
Amortization of Deferred Debt-Related Costs included in Interest Expense 1,030 2,394
Provision for Bad Debts 824 943
Deferred Income Taxes 18,942 21,061
(Gains) Losses from Equity Method Entities (563) (6,893)
Other 12,936 2,595
Changes in Assets and Liabilities which Provided (Used)
Cash Exclusive of Changes Shown Separately
Accounts Receivable 34,038 15,343
Materials and Fuel Inventory (5,368) (621)
Accounts Payable (33,660) (11,984)
Interest Accrued (29,329) (30,826)
Income Tax Receivable (6,045) (3,561)
Taxes Accrued (7,958) (3,313)
Other Current Assets 27,676 (17,357)
Other Current Liabilities (16,438) 26,314
-------------------------------------------------------------------------------------------------------------------------
NET CASH FLOWS - OPERATING ACTIVITIES $ 40,052 $ 44,039
=========================================================================================================================
27
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONCLUDED)
--------------------------------------------------------------------------------
TEP
--------------------------------
Three Months Ended
March 31,
2005 2004
-------------------------------------------------------------------------------------------------------------------------
-Thousands of Dollars-
NET INCOME $ (4,690) $ 794
ADJUSTMENTS TO RECONCILE NET INCOME
TO NET CASH FLOWS
Depreciation and Amortization Expense 30,020 30,413
Depreciation Recorded to Fuel and Other O&M Expense 1,570 1,556
Amortization of Transition Recovery Asset 9,487 8,597
Net Unrealized Gain on TEP Forward Electric Sales 817 (509)
Net Unrealized Loss on TEP Forward Electric Purchases (1,151) 327
Amortization of Deferred Debt-Related Costs included in Interest Expense 917 2,317
Provision for Bad Debts 719 560
Deferred Income Taxes 22,615 21,970
Gains from Equity Method Entities (23) (33)
Interest on Note Receivable from UniSource Energy (1,683) (2,320)
Other 3,241 (218)
Changes in Assets and Liabilities which Provided (Used)
Cash Exclusive of Changes Shown Separately
Accounts Receivable 22,786 10,149
Materials and Fuel Inventory (3,373) 257
Accounts Payable (16,105) (6,611)
Interest Accrued (27,171) (27,943)
Interest Received from UniSource Energy 11,013 -
Income Tax Receivable (6,972) (8,813)
Taxes Accrued (8,520) (1,628)
Other Current Assets 6,660 5,506
Other Current Liabilities (2,886) 1,165
-------------------------------------------------------------------------------------------------------------------------
NET CASH FLOWS - OPERATING ACTIVITIES $ 37,271 $ 35,536
=========================================================================================================================
NOTE 14. REVIEW BY INDEPENDENT ACCOUNTANTS
-------------------------------------------
With respect to the unaudited condensed consolidated financial information
of UniSource Energy and TEP for the three-month period ended March 31, 2005 and
2004, PricewaterhouseCoopers LLP reported that they have applied limited
procedures in accordance with professional standards for a review of such
information. However, their separate report dated May 6, 2005 appearing herein
states that they did not audit and they do not express an opinion on that
unaudited condensed consolidated financial information. Accordingly, the degree
of reliance on their report on such information should be restricted in light of
the limited nature of the review procedures applied. PricewaterhouseCoopers LLP
is not subject to the liability provisions of Section 11 of the Securities Act
of 1933 (the Act) for their report on the unaudited condensed consolidated
financial information because that report is not a "report" or a "part" of a
registration statement prepared or certified by PricewaterhouseCoopers LLP
within the meaning of Sections 7 and 11 of the Act.
28
ITEM 2. - MANAGEMENT'S DISCUSSI0N AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
--------------------------------------------------------------------------------
Management's Discussion and Analysis explains the results of operations,
the general financial condition, and the outlook for UniSource Energy and its
four primary business segments and includes the following:
o outlook and strategies,
o operating results during the first quarter of 2005 compared with the
same period in 2004,
o factors which affect our results and outlook,
o liquidity, capital needs, capital resources, and contractual
obligations,
o dividends, and
o critical accounting estimates.
Management's Discussion and Analysis should be read in conjunction with
UniSource Energy and TEP's 2004 Annual Report on Form 10-K and with the
Condensed Consolidated Financial Statements, beginning on page 2, which present
the results of operations for the three months ended March 31, 2005 and 2004.
Management's Discussion and Analysis explains the differences between periods
for specific line items of the Condensed Consolidated Financial Statements.
References in this report to "we" and "our" are to UniSource Energy and its
subsidiaries, collectively.
UNISOURCE ENERGY CONSOLIDATED
OVERVIEW OF CONSOLIDATED BUSINESS
---------------------------------
UniSource Energy is a holding company that has no significant operations of
its own. Operations are conducted by UniSource Energy's subsidiaries, each of
which is a separate legal entity with its own assets and liabilities. UniSource
Energy owns substantially all of the outstanding common stock of TEP, and all of
the outstanding common stock of UniSource Energy Services, Inc. (UES),
Millennium Energy Holdings, Inc. (Millennium), and UniSource Energy Development
Company (UED).
TEP, an electric utility, has provided electric service to the community of
Tucson, Arizona, for over 100 years. UES began operations in August 2003. UES
through its two operating subsidiaries, UNS Gas, Inc. (UNS Gas) and UNS
Electric, Inc. (UNS Electric), provides gas and electric service to 30
communities in northern and southern Arizona. Millennium invests in unregulated
businesses, including Global Solar Energy, Inc. (Global Solar), a developer and
manufacturer of thin-film photovoltaic cells and modules. UED engages in
developing generating resources and other project development activities,
including facilitating the expansion of the Springerville Generating Station,
but has no significant operations. We conduct our business in four primary
business segments - TEP's Electric Utility segment, UNS Gas, UNS Electric and
Global Solar.
UniSource Energy was incorporated in the State of Arizona on March 8, 1995
and obtained regulatory approval to form a holding company in November 1997. On
January 1, 1998, TEP and UniSource Energy exchanged shares of stock resulting in
TEP becoming a subsidiary of UniSource Energy. Following the share exchange, TEP
transferred the stock of its subsidiary Millennium to UniSource Energy. See Note
3 of Notes to Condensed Consolidated Financial Statements - Debt and Credit
Facilities.
OUTLOOK AND STRATEGIES
----------------------
OPERATING PLANS AND STRATEGIES
Our financial prospects and outlook for the next few years will be affected
by many competitive, regulatory and economic factors. Our plans and strategies
include the following:
o Continue to integrate UES' businesses with UniSource Energy's other
businesses.
o Oversee the construction of Springerville Unit 3 and continue to
enhance the value of existing assets by working with Salt River
Project to facilitate the development of Springerville Unit 4.
29
o Strengthen the capital structure of TEP by using proceeds from the
UniSource Energy convertible notes, borrowings under the UniSource
Energy term loan and some of our excess cash flows to make capital
contributions to TEP and reduce TEP's debt.
o Enhance the value of TEP's transmission system while continuing to
provide reliable access to generation for TEP and UES' retail
customers and market access for all generating assets.
o Promote economic development in our service territories.
o Efficiently manage our generation, transmission and distribution
resources and look for ways to control our operating expenses while
maintaining and enhancing reliability and profitability.
o Expand TEP's and UNS Electric's portfolio of generating and purchased
power resources to meet growing retail energy demand.
o Increase production and sales of Global Solar's thin-film photovoltaic
cells and seek additional investors, or sell all or part of
Millennium's interest, or a combination of both.
o Manage the exit of our other Millennium investments to maximize their
value to shareholders.
To accomplish our goals, during 2005 we expect TEP to spend approximately
$153 million on capital expenditures, and UNS Gas and UNS Electric to spend
approximately $23 million and $26 million, respectively, on capital
expenditures.
While we believe that our plans and strategies will continue to have a
positive impact on our financial prospects and position, we recognize that we
continue to be highly leveraged, and as a result, our access to the capital
markets may be limited or more expensive than for less leveraged companies.
RESULTS OF OPERATIONS
---------------------
UniSource Energy recorded a net loss of $4 million, or 11 cents per average
basic share of Common Stock, in the first three months of 2005, compared with
net income of $6 million, or 19 cents per average basic share of Common Stock,
in the same period of 2004. The following factors contributed to the decline:
o a $12 million decrease in TEP's gross margin (total operating revenues
less fuel and purchased power expense) due to mild winter weather,
resulting in lower retail kWh sales, and higher purchased power costs
related to the planned outage at Springerville Unit 2;
o losses of $2 million at Global Solar, compared with losses of $1
million in the first quarter of 2004; and
o a net loss of $1 million at MEH's other investments, compared with net
income of $3 million in the first quarter of 2004, due primarily to
the sale of an investment; partially offset by
o a $3 million decrease in total interest expense due to lower balances
on long-term debt and capital lease obligations, and lower fees on the
Credit Agreement entered into by TEP in March 2004, compared to the
first quarter of 2004; and
o a $2 million decrease in Other Operations and Maintenance (O&M)
expense. In the first quarter of 2004, O&M included $1 million of
expenses related to the proposed acquisition of UniSource Energy by
Saguaro Utility (Saguaro), while in the first quarter of 2005, TEP
reduced O&M expense due to a $1 million pre-tax gain on the sale of
emissions allowances.
CONTRIBUTION BY BUSINESS SEGMENT
The table below shows the contributions to our consolidated after-tax
earnings by our four business segments.
30
THREE MONTHS ENDED MARCH 31, 2005 2004
-Millions of Dollars-
------------------------------------- --------------------------------------
BUSINESS SEGMENT
TEP $ (5) $ 1
UNS Gas 4 4
UNS Electric 1 1
Global Solar (2) (1)
Other (1) (2) 1
------------------------------------- ------------------ -------------------
Consolidated Net Income $ (4) $ 6
===================================== ================== ===================
(1) Includes: for 2005, interest expense (net of tax) on the
convertible note offering by UniSource Energy; interest expense (net of
tax) on the note payable from UniSource Energy to TEP; costs associated
with the proposed acquisition of UniSource Energy by Saguaro as
previously discussed; UniSource Energy parent company expenses; income
and losses from other Millennium investments; and income and losses from
UED.
LIQUIDITY AND CAPITAL RESOURCES
-------------------------------
UNISOURCE ENERGY CONSOLIDATED CASH FLOWS
THREE MONTHS ENDED MARCH 31, 2005 2004
-Millions of Dollars-
------------------------------------ ---------------- -----------------
Cash provided by (used in):
Operating Activities $ 40 $ 44
Investing Activities (31) (28)
Financing Activities 41 (56)
------------------------------------ ---------------- -----------------
Net Increase (Decrease) in Cash $ 50 $ (40)
==================================== ================ =================
UniSource Energy's consolidated cash flows are provided primarily from
retail and wholesale energy sales at TEP and UES, net of the related payments
for fuel and purchased power. Cash from operations is lowest in the first
quarter and highest in the third quarter due to TEP's summer peaking load.
We use our available cash primarily to:
o finance capital expenditures at TEP, UNS Gas and UNS Electric;
o pay dividends to shareholders; and
o reduce leverage at TEP by repaying or repurchasing debt and investing
in lease debt.
The primary source of liquidity for UniSource Energy, the parent company,
is dividends it receives from its subsidiaries, primarily TEP. Under our tax
sharing agreement, our subsidiaries make income tax payments to UniSource
Energy, which makes payments on behalf of the consolidated group.
As part of our ACC Holding Company Order, we must invest at least 30% of
any proceeds of UniSource Energy equity issuances in TEP until TEP's equity
reaches 37.5% of total capital (excluding capital leases).
As of May 4, 2005, cash and cash equivalents available to UniSource Energy
was approximately $94 million. This balance includes proceeds from UniSource
Energy's Convertible Senior Notes issued March 1, 2005. See Convertible Senior
Notes, below.
OPERATING ACTIVITIES
In the first three months of 2005, net cash flows from operating activities
decreased by $4 million compared with the same period in 2004. The following
factors contributed to the increase:
o an $8 million decline in cash receipts from electric and gas sales,
net of fuel and purchased power costs paid, due to the planned outage
at Springerville Unit 2 and mild winter weather in TEP's service
territory; partially offset by
31
o a $4 million decrease in total taxes paid, net of income tax refunds
received, due to a smaller final tax payment related to prior year
consolidated income tax returns.
INVESTING ACTIVITIES
Net cash used for investing activities was $3 million higher in the first
three months of 2005 compared with the same period in 2004, primarily due to the
following factors:
o capital expenditures were $14 million higher in the first three months
of 2005 due primarily to a planned maintenance outage at Springerville
and TEP's share of the construction costs of the Luna Energy Facility;
partially offset by
o other cash receipts of $6 million in the first three months of 2005
due primarily to the redemption of a $5 million certificate of deposit
at TEP; and
o $4 million used in the first three months of 2004 to purchase
Springerville lease debt at TEP.
FINANCING ACTIVITIES
Net cash flows from financing activities was $41 million in the first three
months of 2005 compared with net cash used for financing activities of $56
million in the first three months of 2004. The following factors contributed to
the change:
o UniSource Energy issued $150 million of Convertible Senior Notes in
March 2005;
o TEP redeemed $53 million of First Mortgage Bonds in March 2005; and
o TEP's payments on capital lease obligations were $5 million higher in
the first three months of 2005.
As a result of the activities described above, our consolidated cash and
cash equivalents increased to $204 million at March 31, 2005, from $154 million
at December 31, 2004. We invest cash balances in high-grade money market
securities with an emphasis on preserving the principal amounts invested.
At May 4, 2005, our consolidated cash balance, including cash equivalents,
was approximately $94 million. This balance includes proceeds from UniSource
Energy's Convertible Senior Notes issued March 1, 2005. See Convertible Senior
Notes, below.
In the event that we experience lower cash from operations in 2005, we will
adjust our discretionary uses of cash accordingly. We believe, however, that we
will continue to have sufficient cash flow to cover our capital needs, as well
as required debt payments and dividends to shareholders.
Convertible Senior Notes
------------------------
On March 1, 2005, UniSource Energy issued $150 million aggregate principal
amount of 4.50% Convertible Senior Notes (Convertible Senior Notes) due 2035 in
a private placement. The Convertible Senior Notes are unsecured. Each $1,000
principal amount of Convertible Senior Notes is convertible into 26.6667 shares
of UniSource Energy Common Stock at any time, representing a conversion price of
approximately $37.50 per share of our Common Stock, subject to adjustment in
certain circumstances.
The Convertible Senior Notes bear interest at an annual rate of 4.50%
payable semi-annually in arrears on each March 1 and September 1, commencing on
September 1, 2005. In addition, beginning on March 1, 2015, the Convertible
Senior Notes will also, in certain circumstances, bear contingent interest at
the annual rate of 0.35%.
Beginning on March 5, 2010, we will have the option to redeem the
Convertible Senior Notes, in whole or in part, for cash, at a price equal to
100% of the principal amount plus accrued interest. If certain change of control
transactions occur, or our common stock is no longer listed on a national
securities exchange, holders of the Convertible Senior Notes may require
32
UniSource Energy to repurchase the Convertible Senior Notes, in whole or in
part, for cash. If one of these events occurs prior to March 5, 2010, we may be
required to pay a make-whole premium payable in shares of common stock.
Additionally, the holders of the Convertible Senior Notes may require us to
repurchase for cash, all or part, of the Convertible Senior Notes on March 1,
2015, 2020, 2025 and 2030. The repurchase price will be 100% of the principal
amount of the Convertible Senior Notes plus accrued interest.
The Convertible Senior Notes may become immediately payable if an event of
default occurs. An event of default includes failure to make required payments
on the Convertible Senior Notes, acceleration of $50 million or more of
indebtedness for borrowed money at UniSource Energy or TEP or certain bankruptcy
events at UniSource Energy or TEP. Neither TEP nor any other subsidiary of
UniSource Energy has guaranteed UniSource Energy's obligations on the
Convertible Senior Notes.
UniSource Credit Agreement
--------------------------
On April 15, 2005, UniSource Energy entered into a $105 million five-year
credit agreement with a group of lenders (UniSource Credit Agreement) which
expires on April 15, 2010. The UniSource Credit Agreement includes a $90 million
term loan facility and a $15 million revolving credit facility. In addition,
UniSource Energy is required to make quarterly payments of $1.25 million
beginning June 2005 with the balance due at maturity.
Interest is payable on borrowings under the UniSource Credit Agreement at a
Eurodollar rate or Alternate Base Rate rate. Eurodollar loans would bear
interest at adjusted LIBOR plus 1.75%. Alternate Base Rate loans would bear
interest in an amount equal to the sum of (1) the greater of the federal funds
rate plus 1/2 of 1% or the agent bank's reference rate, and (2) 0.75%. In the
event that, after June 30, 2005, TEP, because of regulatory restrictions, does
not have the ability to pay 100% of its current year net income as dividends,
interest rates would increase by 0.25%.
The UniSource Credit Agreement contains a number of covenants restricting
additional indebtedness, liens, mergers, sales of assets and investments and
acquisitions. Additionally, the UniSource Credit Agreement contains several
financial covenants including: (1) a minimum cash flow to interest coverage
ratio determined on a UniSource Energy standalone basis and (2) a maximum
leverage ratio determined on a consolidated basis. The UniSource Credit
Agreement allows UniSource Energy to pay dividends, if after giving effect to
the dividend payment, UniSource Energy and it subsidiaries have more than $15
million of unrestricted cash and unused revolving credit.
The UniSource Credit Agreement may become immediately payable if an event
of default occurs. An event of default includes failure to make required
payments under the UniSource Credit Agreement, failure of UniSource Energy or
certain subsidiaries to make payments or default on debt greater than $20
million, or certain bankruptcy events at UniSource Energy or certain
subsidiaries. The UniSource Credit Agreement is collateralized by a pledge of
the capital stock of Millennium, UES and UED.
UniSource Energy expects that borrowings will be made from time to time
under the revolving credit facility component of the UniSource Credit Agreement
to meet temporary cash needs.
Use of Proceeds
---------------
On March 1, 2005, UniSource Energy used $106 million of the net proceeds
from the sale of the Convertible Senior Notes to repay its $95 million
promissory note to TEP plus accrued interest of $11 million.
UniSource Energy expects to borrow the entire $90 million available under
the term loan facility by June 30, 2005 and use the proceeds to make a capital
contribution to TEP. It is anticipated that this $90 million capital
contribution, together with the proceeds TEP received from the $95 million
inter-company note repayment in March 2005 (described above) and any additional
capital contributions to TEP from the proceeds of UniSource Energy's issuance of
the Convertible Senior Notes in March 2005, will be used by TEP to repurchase or
redeem $225 million of fixed-rate tax-exempt debt obligations.
As stated in a recently expired tender offer, TEP has agreed to purchase
$147 million of its 1997 Pima Series B and $74 million of its 1997 Pima Series C
fixed-rate tax-exempt debt obligations (Repurchased Bonds) from bondholders on
May 11, 2005, at a price of $101.50 per $100 principal amount. Additionally, TEP
will redeem at par $4 million of bonds not tendered on May 18, 2005. TEP does
not plan on canceling the Repurchased Bonds. The Repurchased Bonds will remain
outstanding under their respective indentures; however, the Repurchased Bonds
will not be presented in our financial statements. TEP may choose to cancel or
33
resell the Repurchased Bonds to third parties in the future. Upon completion of
these purchases and redemptions in the principal amount of $225 million, TEP
expects its ratio of equity to total capitalization (excluding capital leases)
will improve to 40%, thereby allowing TEP to dividend up to 100% of its current
year net income to UniSource Energy. See, Tucson Electric Power, Bond
Repurchases and Redemptions, and Tucson Electric Power Company, Liquidity and
Capital Resources, Dividends on Common Stock, below.
On March 10, 2005, UniSource Energy used $10 million of the net proceeds
from the sale of the Convertible Senior Notes to make an equity contribution of
$6 million to UNS Gas and an equity contribution of $4 million to UNS Electric.
GUARANTEES AND INDEMNITIES
In the normal course of business, UniSource Energy and certain subsidiaries
enter into various agreements providing financial or performance assurance to
third parties on behalf of certain subsidiaries. We enter into these agreements
primarily to support or enhance the creditworthiness of a subsidiary on a
stand-alone basis. The most significant of these guarantees are UES' guarantee
of $160 million of aggregate principal amount of senior unsecured notes issued
by UNS Gas and UNS Electric to purchase the Citizens Communication Company
(Citizens') Arizona gas and electric system assets, UES' guarantee of a $40
million revolving credit facility available to UNS Gas and UNS Electric,
UniSource Energy's guarantee of approximately $8 million in natural gas and
supply payments and building lease payments for UNS Gas and UNS Electric, and
subsidiaries of Millennium, and Millennium's guarantee of approximately $2
million in commodity-related payments for MEG at March 31, 2005. To the extent
liabilities exist under the contracts subject to these guarantees, such
liabilities are included in the consolidated balance sheets.
In addition, UniSource Energy and its subsidiaries have indemnified the
purchasers of interests in certain investments from additional taxes due for
years prior to the sale. The terms of the indemnifications provide for no
limitation on potential future payments; however, we believe that we have abided
by all tax laws and paid all tax obligations. We have not made any payments
under the terms of these indemnifications to date.
We believe that the likelihood that UniSource Energy or TEP would be
required to perform or otherwise incur any significant losses associated with
any of these guarantees is remote.
CONTRACTUAL OBLIGATIONS
There are no significant changes in our contractual obligations or other
commercial commitments from those reported in our 2004 Annual Report on Form
10-K, other than the UniSource Energy Credit Agreement (described above) and the
UNS Gas/UNS Electric Credit Agreement, described below.
DIVIDENDS ON COMMON STOCK
The following table shows the declared dividends to UniSource Energy
shareholders for 2005.
DIVIDEND AMOUNT
DECLARATION DATE RECORD DATE PAYABLE DATE PER SHARE OF COMMON STOCK
---------------- ------------------- ------------- --------------------------
February 4, 2005 February 15, 2005 March 8, 2005 $0.19
May 6, 2005 May 18, 2005 June 10, 2005 $0.19
---------------- ------------------- ------------- --------------------------
INCOME TAX POSITION
At March 31, 2005, UniSource Energy and TEP had, for federal and state
income tax filing purposes, the following carryforward amounts:
UNISOURCE ENERGY TEP
Amount Expiring Amount Expiring
------------------------------ ---------------------- ------------- ----------------------- -------------
-Millions of Dollars- Year -Millions of Dollars- Year
NET OPERATING LOSSES $ 18 2021-2022 $ - -
INVESTMENT TAX CREDIT 5 2004-2024 5 2004-2024
AMT CREDIT 100 - 92 -
------------------------------ ---------------------- ------------- ----------------------- -------------
34
The $18 million in NOL carryforwards is subject to limitation due to a
reorganization of certain Millennium entities in December 2002. The future use
of these losses is dependant upon the generation of sufficient future taxable
income at the separate company level. See Critical Accounting Estimates,
Deferred Tax Valuation - TEP and Millennium, below.
TUCSON ELECTRIC POWER COMPANY
RESULTS OF OPERATIONS
---------------------
The financial condition and results of operations of TEP are currently the
principal factors affecting the financial condition and results of operations of
UniSource Energy on an annual basis. The following discussion relates to TEP's
utility operations, unless otherwise noted.
SALES OPERATING REVENUE
THREE MONTHS ENDED MARCH 31, 2005 2004 2005 2004
-Millions of kWh- -Millions of Dollars-
--------------------------------------------- -------------- ------------- ------------ --------------
ELECTRIC RETAIL SALES:
Residential 649 719 $ 55 $ 58
Commercial 351 358 36 37
Industrial 512 490 36 36
Mining 220 192 10 9
Public Authorities 44 50 3 3
--------------------------------------------- -------------- ------------- ------------ --------------
TOTAL ELECTRIC RETAIL SALES 1,776 1,809 140 143
--------------------------------------------- -------------- ------------- ------------ --------------
ELECTRIC WHOLESALE SALES DELIVERED:
Long-term Contracts 308 346 14 15
Other Sales 454 543 24 25
Transmission - - 2 2
Net Unrealized Gain (Loss) on Forward
Sales of Energy - - (1) -
--------------------------------------------- -------------- ------------- ------------ --------------
TOTAL ELECTRIC WHOLESALE SALES 762 889 39 42
--------------------------------------------- -------------- ------------- ------------ --------------
TOTAL ELECTRIC SALES 2,538 2,698 $ 179 $ 185
============================================= ============== ============= ============ ==============
WEATHER DATA:
Heating Degree Days 775 877
10-Year Average 796 796
% Over / (Under) Prior Year (12%) 28%
% Over / (Under) 10-Year Average (3%) 10%
--------------------------------------------- -------------- ------------- ------------ --------------
Total revenues from kWh sales to retail customers decreased by $3 million,
or 2%, in the first quarter of 2005 compared with the first quarter of 2004,
resulting from lower energy demand from residential customers. Heating degree
days were 12% lower than last year and 3% lower than the 10-year average. Higher
mining and industrial kWh sales partially offset the lower residential demand.
The average price of copper was 10% higher in first quarter of 2005 compared
with the same period last year, leading to increased mining activity and a 15%
increase in kWh sales to TEP's mining customers; revenues from TEP's mining
customers increased $1 million. Total retail kWh sales decreased by 2% in the
first quarter of 2005 compared with the same period last year.
Wholesale revenues decreased $3 million, or 7%, in the first quarter of
2005 compared with the first quarter of 2004. Wholesale sales opportunities were
limited in the first quarter of 2005 due to a planned outage at TEP's
Springerville Unit 2. The average wholesale market price of energy was $45 per
MWh in 2005, compared with $40 per MWh in 2004. See Factors Affecting Results of
Operations, Western Energy Markets, Market Prices, below.
OPERATING EXPENSES
FUEL AND PURCHASED POWER EXPENSE
TEP's fuel and purchased power expense, and energy resources for the first
quarters of 2005 and 2004 are shown in the table below.
35
GENERATION EXPENSE
THREE MONTHS ENDED MARCH 31, 2005 2004 2005 2004
-Millions of kWh- -Millions of Dollars-
-------------------------------------------- ----------------------- -------------------------
Coal-Fired Generation 2,405 2,763 $ 42 $ 47
Gas-Fired Generation 56 12 5 -
-------------------------------------------- --------- ------------- ------------ -------------
Total Generation 2,461 2,775 47 47
Purchased Power 268 95 13 6
-------------------------------------------- --------- ------------- ------------ -------------
Total Resources 2,729 2,870 $ 60 $ 53
============ =============
Less Line Losses, Company Use and Other 191 172
-------------------------------------------- --------- -------------
Total Energy Sold 2,538 2,698
-------------------------------------------- --------- -------------
A planned outage at TEP's 380-megawatt coal-fired Springerville Unit 2
facility led to higher gas-related fuel costs and higher purchased power
expenses during the first three months of 2005. Total fuel expense at TEP's
generating plants was $47 million in the first three months of both 2005 and
2004. Coal-related fuel expense was $5 million lower than last year due to the
planned outage of Springerville Unit 2. Gas-related fuel expense increased $5
million due to the higher use of TEP's gas-fired generating resources as well as
higher commodity prices for gas. The average price per MMBtu of gas at the
Permian basin was up 11% compared with the first quarter of 2004.
Purchased power expense increased $7 million compared with the first
quarter of 2004, due to replacement power purchases and higher wholesale energy
prices. Average wholesale energy prices on the Dow Jones Palo Verde Index were
up 13% compared with last year. See Factors Affecting Results of Operations,
Western Energy Markets, Market Prices, below.
The table below shows the average cost per kWh for TEP's generating plants
by fuel type.
2005 2004
-cents per kWh-
------------------------------ ------------------- ------------------
Coal 1.75 1.70
Gas 8.93 8.33
All fuels 1.91 1.71
------------------------------ ------------------- ------------------
OTHER OPERATING EXPENSES
Other O&M expense was unchanged in the first quarter of 2005 compared with
the same period in 2004.
Amortization of the Transition Recovery Asset (TRA) increased $1 million in
the first quarter of 2005. Amortization of the TRA is the result of the 1999
Settlement Agreement (TEP Settlement Agreement) with the ACC, which changed the
accounting method for TEP's generation operations. This item reflects the
recovery, through 2008, of transition recovery assets which were previously
regulatory assets of the generation business. The amount of amortization is a
function of the TRA balance and total kWh consumption by TEP's distribution
customers.
The table below shows estimated TRA amortization and unamortized TRA
balances for the remainder of 2005 through 2008.
FUTURE ESTIMATED UNAMORTIZED
TRA AMORTIZATION TRA BALANCE
-Millions of Dollars-
----------------------- ---------------------------- -------------------
2005 $ 55 $ 169
2006 64 105
2007 73 32
2008 32 -
----------------------- ---------------------------- -------------------
OTHER INCOME (DEDUCTIONS)
36
TEP's Income statement includes inter-company Interest Income of $2 million
in the first quarter of 2005, and $2 million in the first quarter of 2004. This
represented Interest Income on a promissory note TEP received from UniSource
Energy in exchange for the transfer to UniSource Energy of its stock in
Millennium in 1998. On UniSource Energy's Consolidated Statement of Income, this
Interest Income, as well as UniSource Energy's related interest expense, was
eliminated as an inter-company transaction. In March 2005, UniSource Energy
repaid the inter-company promissory note. See Liquidity and Capital Resources,
TEP Cash Flows, Inter-Company Note from UniSource Energy, below.
INTEREST EXPENSE
Total Interest Expense decreased by $3 million, or 9%, in the first quarter
of 2005 due to: lower Letter of Credit fees on the Credit Agreement entered into
by TEP in March 2004; lower interest expense resulting from the July 2004
redemption of $27 million of 8.5% First Mortgage Bonds; and fees written off in
March 2004 when TEP refinanced its Credit Agreement.
INCOME TAX EXPENSE
TEP recorded Income Tax Benefits of $2 million in the first quarter of 2005
due to a $7 million Loss Before Income Taxes. In the first quarter of 2004, TEP
recorded Income Tax Expense of $2 million.
FACTORS AFFECTING RESULTS OF OPERATIONS
---------------------------------------
COMPETITION
The electric utility industry has undergone significant regulatory change
in the last few years designed to encourage competition in the sale of
electricity and related services. However, the recent experience in California
with deregulation has caused many states, including Arizona, to re-examine the
viability of retail electric deregulation.
As of January 1, 2001, all of TEP's retail customers are eligible to choose
an alternate energy supplier. Currently none of TEP's retail customers are
receiving service from other providers. TEP has met all conditions required by
the ACC to facilitate electric retail competition, including ACC approval of
TEP's direct access tariffs. ESPs must meet certain conditions before
electricity can be sold competitively in TEP's service territory. Examples of
these conditions include ACC certification of ESPs, and execution of and
compliance with direct access service agreements with TEP.
In January 2005, an Arizona Court of Appeals decision became final in which
the Court held invalid certain portions of the ACC rules on retail competition
and related market pricing. Based on this decision, we expect that the ACC will
address the competition rules in an administrative proceeding during 2005. We
cannot predict what changes, if any, the ACC will make to the competition rules.
See Rates, Recent Motion Filed with ACC, below.
TEP competes against gas service suppliers and others that provide energy
services. Other forms of energy technologies may provide competition to TEP's
services in the future, but to date, are not financially viable alternatives for
its retail customers. Self-generation by TEP's large industrial customers could
also provide competition for TEP's services in the future, but has not had a
significant impact to date.
In the wholesale market, TEP competes with other utilities, power marketers
and independent power producers in the sale of electric capacity and energy.
RATES
TEP'S SETTLEMENT AGREEMENT AND RETAIL ELECTRIC COMPETITION RULES
In September 1999, the ACC approved the Retail Electric Competition Rules
(Rules) that provided a framework for the introduction of retail electric
competition in Arizona. In November 1999, the ACC approved the Settlement
Agreement between TEP and certain customer groups related to the implementation
of retail electric competition in Arizona.
The Rules and the Settlement Agreement established:
o a period, November 1999 through 2008, for TEP to transition its
generation assets from a cost of service based rate structure to a
market, or competitive, rate structure;
37
o the recovery through rates during the transition period of $450
million of stranded generation costs through a fixed competitive
transition charge (fixed CTC);
o capped rates for TEP retail customers through 2008;
o an ACC interim review of TEP retail rates in 2004;
o unbundling of electric services with separate rates or prices for
generation, transmission, distribution, metering, meter reading,
billing and collection, and ancillary services;
o a process for Energy Service Providers (ESPs) to become licensed by
the ACC to sell generation services at market prices to TEP retail
customers;
o access, as noted above, for TEP retail customers to buy market priced
generation services from ESPs beginning in 2000 (currently, no TEP
customers are purchasing generation services from ESPs);
o transmission and distribution services would remain subject to
regulation on a cost of service basis; and
o beginning in 2009, TEP's generation would be market based and its
retail customers would pay the market rate for generation services.
2004 General Rate Case Information
----------------------------------
On June 1, 2004, as required by the Settlement Agreement, TEP filed general
rate case information with the ACC. TEP's filing does not propose any change in
retail rates, and under the terms of the Settlement Agreement, no rate case
filed by TEP through 2008 may result in a net rate increase. However, absent the
restriction on raising rates, TEP believes that the data in its filing would
justify an increase in retail rates of 16%.
The general rate case information uses a historical test year ended
December 31, 2003 and establishes, based on TEP's standard offer service, that
TEP is experiencing a revenue deficiency of $111 million. The rate case
information includes, among other things, Springerville Unit 1 costs and other
generation costs including fuel costs in excess of those recovered through
existing rates. The proposed weighted cost of capital for the test year ended
December 31, 2003 is 8.78%, including an 11.5% return on equity (increased from
10.67% currently authorized). The rate case information uses a hypothetical 40%
equity capitalization (excluding capital lease obligations) rather than the
hypothetical 37.5% equity capitalization used in TEP's last general rate case.
TEP's actual equity capitalization (excluding capital lease obligations) at
March 31, 2005 was 29.6%. As discussed above, in the first half of 2005, TEP
expects to increase common equity to 40% of capitalization (excluding capital
lease obligations). See TEP, Dividends on Common Stock, below for further
information regarding improvements to TEP's capital structure. Despite the
indicated revenue deficiency, the ACC could conclude that TEP should decrease
rates after June 1, 2005; any such determination would be strongly opposed by
TEP.
A procedural order was issued in February 2005 that outlined how the review
of TEP's general rate case information will proceed. The schedule calls for
staff and intervenor testimony to be filed by June 13, 2005 and hearings, as
appropriate, before the administrative law judge to begin September 12, 2005.
Transition
----------
The Settlement Agreement provides that TEP's fixed CTC will expire when
TEP's $450 million transition asset is fully amortized and recovered or on
December 31, 2008, whichever is earlier. Based on current projections of retail
sales, the transition recovery asset is expected to be fully amortized by
mid-2008. The Settlement Agreement also specifies that TEP's floating
competitive transition charge (floating CTC) will expire on December 31, 2008.
This charge, which moves inversely to changes in market-based generation
services rates, presently appears as a credit on retail customer bills. Based on
current forward pricing in the wholesale energy markets, TEP anticipates that
the floating CTC will continue to appear as a credit on retail customer bills
through 2008. After the expiration of the floating CTC, TEP's rates for
generation services should be market based. TEP anticipates that it will submit
a rate filing to address the rates that will go into effect after the expiration
of the 1999 Settlement Agreement.
Absent any other change to TEP's retail rate structure, including continued
inability to recover actual costs, TEP estimates that the expiration of the
fixed CTC in 2008 (which has provided revenues, on average of .93 cents per kWh
sold) would result in an average decrease in revenues from retail rates of
approximately 12% relative to revenues from current retail rates. However,
absent any other change except the expiration of the fixed CTC, the expiration
in 2008 of the floating CTC would result in market-based generation services
rates which would, based on current pricing in the wholesale energy markets,
produce a retail rate increase in January 2009 of approximately 10-15% relative
to current retail rates.
38
We are operating pursuant to the TEP Settlement Agreement. However, we
cannot predict the future rate methodologies for TEP which the ACC could
authorize, including whether the ACC will permit or require market-based rates
for generation services, reinstate cost of service ratemaking for all or a
portion of TEP's generation services or require an alternate methodology to
determine rates for TEP's generation services. Under any circumstances, TEP will
seek appropriate recovery and return on its investment in assets used to serve
its customers.
In the event that the ACC reinstates cost of service ratemaking for TEP's
generation services and does not allow other factors that have changed in the
intervening years to be considered, significant retail rate decreases could
occur. TEP expects that, in establishing future rates, TEP and the ACC will
review the entirety of the retail rate structure rather than focusing solely on
any one of the elements noted above. Although TEP is unable to predict the type
and level of future retail rates, TEP believes that the 2004 general rate case
information filed with the ACC evidences that there have been a number of
factors that have changed since the Settlement Agreement was approved that
justify increasing or maintaining retail rates at current levels.
Recent Motion Filed with ACC
----------------------------
Given the recent court action described above, the ACC may revise its Rules
and rate methodologies prior to the expiration in 2008 of the TEP Settlement
Agreement. A new structure could replace that established pursuant to the TEP
Settlement Agreement prior to January 2009.
In an effort to resolve the uncertainty surrounding the continued
applicability of the Rules and the methodology that will be applied to determine
TEP's rates for generation service after the CTCs expire, TEP filed a motion
with the ACC on May 4, 2005 requesting that the ACC issue an order declaring its
position regarding the status of the Rules and the rate treatment that will be
afforded to TEP's generation assets after 2008.
The motion states TEP's preference for the ACC to adhere to the 1999
Settlement Agreement and continue to authorize TEP to charge market-based rates
for generation services after December 31, 2008. The motion also states that, if
the ACC intends to rescind TEP's authorization to charge market-based rates for
its generation services, that change will have immediate consequences for the
Settlement Agreement, the 2004 general rate case information filing and future
TEP rate cases. Accordingly, TEP requested that the ACC clarify its intentions
in this regard. In addition, TEP requested that a procedural conference be held
in the 2004 rate review proceedings to discuss the status of that case pending
the issuance of an order in response to TEP's motion. TEP cannot predict when,
or how, the ACC will respond to the motion.
WESTERN ENERGY MARKETS
As a participant in the western U.S. wholesale power markets, TEP is
directly and indirectly affected by changes in market conditions and market
participants. TEP competes with other utilities, power marketers and independent
power producers in the sale of electric capacity and energy at market-based
rates in the wholesale market.
As of March 31, 2005, electric generating capacity in Arizona has grown to
approximately 25,000 MW; an increase of nearly 60% since 2001. A majority of the
growth over the last three years is the result of 16 new or upgraded gas-fired
generating units with a combined capacity of approximately 9,200 MW. In
addition, the presence of fewer creditworthy counterparties, as well as legal,
political and regulatory uncertainties, has reduced market liquidity and trading
volume.
MARKET PRICES
The average market price for around-the-clock energy based on the Dow Jones
Palo Verde Index increased in the first quarter 2005, as did the average price
for natural gas based on the Permian Index. Average market prices for
around-the-clock energy began to rise in February 2003 and stayed at elevated
levels during 2004 and the first three months of 2005 due to high natural gas
prices from increased demand and production and storage level concerns. As a
result of all of these factors, TEP's natural gas and purchased power expenses
were higher in the first three months of 2005 than the same period in 2004.
Prices have continued in this range to date; however, we cannot predict whether
these higher prices will continue, or whether changes in various factors that
influence demand and supply will cause prices to fall during 2005.
39
AVERAGE MARKET PRICE FOR AROUND-THE-CLOCK ENERGY $/MWH
--------------------------------------------------------- ----------------
Quarter ended March 31, 2005 $ 45
Quarter ended March 31, 2004 40
--------------------------------------------------------- ----------------
AVERAGE MARKET PRICE FOR NATURAL GAS $/MMBTU
--------------------------------------------------------- ----------------
Quarter ended March 31, 2005 $ 5.55
Quarter ended March 31, 2004 5.02
TEP typically uses generation from its facilities fueled by natural gas and
purchased power, in addition to energy from its coal-fired facilities, to meet
the summer peak demands of its retail customers and to meet local reliability
needs. Some of these purchased power contracts are price indexed to natural gas
prices. Short-term and spot power purchase prices are also closely correlated to
natural gas prices. Due to its increasing seasonal gas and purchased power
usage, TEP hedges a portion of its total natural gas exposure from plant fuel
and gas-indexed purchased power with fixed price contracts for a maximum of
three years. TEP currently has approximately 50% of this exposure hedged for the
May through October summer peak period of 2005 at a weighted average price of
$5.50 per MMBtu. TEP purchases its remaining gas fuel needs and purchased power
in the spot and short-term markets.
We expect the market price and demand for capacity and energy to continue
to be influenced by factors including:
o weather;
o continued population growth in the western U.S.;
o economic conditions in the western U.S.;
o availability of generating capacity throughout the western U.S.;
o the extent of electric utility industry restructuring in Arizona,
California and other western states;
o the effect of FERC regulation of wholesale energy markets;
o the availability and price of natural gas;
o availability of hydropower;
o transmission constraints; and
o environmental regulations and the cost of compliance.
LIQUIDITY AND CAPITAL RESOURCES
-------------------------------
TEP CASH FLOWS
TEP's capital requirements consist primarily of capital expenditures and
optional and mandatory redemptions of long-term debt and capital lease
obligations. Cash flow from operations typically is the lowest in the first
quarter and highest in the third quarter due to TEP's summer peaking load.
THREE MONTHS ENDED MARCH 31, 2005 2004
-Millions of Dollars-
----------------------------------------------------------- --------------- --------------
Net Cash Flows - Operating Activities $ 37 $ 36
Capital Expenditures (34) (23)
----------------------------------------------------------- --------------- --------------
Net Cash Flows after Capital Expenditures* 3 13
----------------------------------------------------------- --------------- --------------
Debt Maturities (1) (1)
Retirement of Capital Lease Obligations (48) (44)
Proceeds from Investment in Springerville
Lease Debt and Equity 8 8
----------------------------------------------------------- --------------- -------------
Net Cash Flows Available after Required Payments* $ (38) $ (24)
=========================================================== =============== ==============
* We believe that Net Cash Flows after Capital Expenditures and Net Cash
Flows Available After Required Payments, which are non-GAAP financial
measures, provide useful information to investors as measures of liquidity
and our ability to meet our capital requirements and mandatory redemptions
of debt and capital lease obligations.
During 2005, TEP expects to generate sufficient internal cash flows to fund
its operating activities, construction expenditures, required debt maturities,
and to pay dividends to UniSource Energy. However, TEP's cash flows may vary due
to changes in wholesale revenues, changes in short-term interest rates, and
40
other factors. TEP currently has $60 million available under its Revolving
Credit Facility which it may borrow if cash flows fall short of expectations or
if monthly cash requirements temporarily exceed available cash balances. TEP may
temporarily borrow funds under its Revolving Credit Facility in May 2005 in
connection with the redemption of $225 million of fixed-rate tax-exempt debt.
See UniSource Energy, Liquidity and Capital Resources, UniSource Energy Credit
Agreement, Use of Proceeds, above, and Bond Issuances and Redemptions, below.
OPERATING ACTIVITIES
In the first three months of 2005, net cash flows from operating activities
increased by $1 million compared with the same period in 2004. The following
factors contributed to the increase:
o an $11 million increase in interest received, due primarily to
interest received from UniSource Energy when it repaid its $95 million
inter-company loan to TEP;
o a $5 million decrease in Income Taxes Paid due the timing of payments
in the first three months of 2005 compared with the same period last
year;
o a $3 million decrease in total interest paid due to lower capital
lease obligation balances, lower fees under TEP's Credit Agreement
that was entered into in March 2004 and lower long-term debt balances;
partially offset by
o a $6 million decrease in total cash receipts from retail and electric
wholesale sales, net of fuel and purchased power costs, due to the
planned outage at Springerville Unit 2 and mild winter weather;
o a $5 million increase in wages paid due to higher incentive
compensation compared to last year; and
o a $5 million increase in O&M expense related to the planned outage at
Springerville Unit 2 and maintenance costs at the San Juan Generating
Station.
FINANCING ACTIVITIES
Net cash used for financing activities was $40 million lower in the first
three months of 2005 compared with the same period in 2004. The following
factors contributed to the decrease:
o TEP received $95 million from UniSource Energy as a repayment for an
inter-company loan; and
o TEP spent $8 million in the first three months of 2004 related to
refinancing its Credit Agreement; partially offset by
o a $52 million increase in repayments on long-term debt related to
TEP's early redemption of First Mortgage Bonds in the first three
months of 2005;
o a $5 million increase in scheduled payments made on capital lease
obligations; and
o an increase of $5 million in other cash payments.
At March 31, 2005, there were no outstanding borrowings under TEP's
revolving credit facility.
Inter-Company Note from UniSource Energy
----------------------------------------
On March 1, 2005, UniSource Energy repaid to TEP a debt obligation in the
principal amount of $95 million plus accrued interest of $11 million. TEP
expects that it will use the proceeds during May 2005 to redeem or repurchase
certain of its existing indebtedness through tender offers and redemptions. See
Bond Issuance and Redemptions, below.
Bond Issuance and Redemptions
-----------------------------
41
TEP made the required sinking fund payment of $1 million on its 6.1% First
Mortgage IDBs in January 2005.
In March 2005, TEP redeemed at par the remaining $31 million of its 6.1%
First Mortgage IDBs, which were due in 2008, as well as the remaining $21
million of its 7.5% First Mortgage IDBs, which were due in 2006.
Pursuant to a recently expired tender offer, TEP has agreed to purchase
$147 million of its 1997 Pima Series B and $74 million of its 1997 Pima Series C
fixed-rate tax-exempt debt obligations from bondholders on May 11, 2005, at a
price of $101.50 per $100 principal amount. Additionally, TEP will redeem at par
$4 million of bonds not tendered on May 18, 2005. Upon completion of these
purchases and redemptions in the principal amount of $225 million, TEP expects
the ratio of equity to total capitalization (excluding capital leases) will
improve to 40%, thereby allowing TEP to dividend up to 100% of its current year
net income to UniSource Energy.
Capital Lease Obligations
-------------------------
At March 31, 2005, TEP had $712 million of total capital lease obligations
on its balance sheet. The table below provides a summary of the outstanding
lease amounts.
BALANCE AT
LEASED ASSET 03/31/2005 EXPIRATION
---------------------------------------- --------------------------- ---------------------
- In Millions -
Springerville Unit 1 $427 2014
Springerville Coal Handling Facilities 126 2015
Springerville Common Facilities 104 2020
Sundt Unit 4 54 2010
Other Leases 1 2006
---------------------------------------- --------------------------- ---------------------
Total Capital Lease Obligations $712
======================================== =========================== =====================
Except for TEP's 13% equity interest in the Springerville Coal Handling
Facilities, TEP will not own these assets at the expiration of the leases. TEP
may renew the leases or purchase the leased assets at such time. These renewal
and purchase options are generally for fair market value as determined at that
time.
TEP Credit Agreement
--------------------
On May 4, 2005, TEP entered into a new $401 million Credit Agreement (TEP
Credit Agreement) to replace its previous $401 million credit agreement. The TEP
Credit Agreement includes a $60 million revolving credit facility and a $341
million letter of credit facility to support $329 million aggregate principal
amount of tax-exempt variable rate bonds. The TEP Credit Agreement expires May
4, 2010 and is secured by $401 million of Second Mortgage Bonds.
Covenants in the TEP Credit Agreement restrict additional indebtedness,
liens and sale of assets and sale-leasebacks agreements. The TEP Credit
Agreement also contains several financial covenants including: (1) a minimum
cash coverage ratio, and (2) a maximum leverage ratio. If TEP complies with the
terms of the TEP Credit Agreement, TEP may pay dividends to UniSource Energy.
Certain regulatory actions may cause a decrease in the amount that may be
borrowed.
The TEP Credit Agreement may become immediately due and payable if an event
of default occurs. An event of default includes failure to make required
payments under the TEP Credit Agreement; change in control, as defined; failure
of TEP or certain subsidiaries to make payments or default on debt greater than
$20 million; or certain bankruptcy events at TEP or certain subsidiaries.
Interest rates and fees under the TEP Credit Agreement are based on a
pricing grid tied to TEP's credit ratings. The letter of credit fees are 0.875%
under the TEP Credit Agreement. Amounts drawn under the letter of credit would
currently bear interest based on LIBOR plus 0.875% per annum. Borrowings under
the revolving credit facility bear interest at a variable interest rate
consisting of a spread over LIBOR or an alternate base rate. The per annum rate
currently in effect on borrowings under TEP's revolving credit facility is LIBOR
plus 0.875%. TEP also pays a commitment fee of 0.20% on the unused portion of
the revolving credit facility.
At May 9, 2005, TEP had no outstanding borrowings under the revolving
credit facility component of the TEP Credit Agreement. However, TEP may
temporarily borrow funds in May 2005 in connection with the repurchase and
42
redemption of $225 million of fixed-rate tax-exempt debt. See UniSource Energy,
Liquidity and Capital Resources, UniSource Energy Credit Agreement, Use of
Proceeds, above, and Bond Issuances and Redemptions, above.
Mortgage Indentures
-------------------
TEP's first mortgage indenture and second mortgage indenture create liens
on and security interests in most of TEP's utility plant assets. Springerville
Unit 2, which is owned by San Carlos Resources Inc, a wholly owned subsidiary of
TEP, is not subject to these liens and security interests. TEP's mortgage
indentures allow TEP to issue additional mortgage bonds on the basis of: (1) a
percentage of net utility property additions and/or (2) the principal amount of
retired mortgage bonds. The amount of bonds that TEP may issue is also subject
to a net earnings test under each mortgage indenture.
TEP's Credit Agreement contains limits on the amount of First and Second
Mortgage Bonds that may be outstanding. The TEP Credit Agreement allows no more
than $138 million of First Mortgage Bonds to be outstanding, and no more than a
total of $650 million in First and Second Mortgage Bonds to be outstanding. At
March 31, 2005, TEP had $138 million of First Mortgage Bonds and a total of $539
million in First and Second Mortgage Bonds outstanding. Although the first and
second mortgage indentures would allow TEP to issue additional bonds based on
property additions and/or retired bond credits, the limits imposed by the TEP
Credit Agreement are more restrictive and are currently the governing
limitations.
Under the terms of the TEP Credit Agreement, TEP has committed to use
commercially reasonable efforts to substitute Second Mortgage Bonds for First
Mortgage Bonds collateralizing the $138 million of First Collateral Trust Bonds
outstanding, and to terminate TEP's First Mortgage Indenture.
CONTRACTUAL OBLIGATIONS
There have been no significant changes in TEP's contractual obligations or
other commercial commitments from those reported in TEP's 2004 Annual Report on
Form 10-K.
DIVIDENDS ON COMMON STOCK
TEP can pay dividends if it maintains compliance with the TEP Credit
Agreement and certain financial covenants. As of March 31, 2005, TEP was in
compliance with the terms of its then existing Credit Agreement.
The ACC Holding Company Order stated that TEP may not pay dividends to
UniSource Energy in excess of 75% of its earnings until TEP's common equity
equals 37.5% of total capitalization (excluding capital lease obligations). The
Citizens Settlement Agreement, as approved by the ACC, modified this dividend
limitation so that it will remain in place until TEP's common equity equals 40%
of total capitalization (excluding capital lease obligations). As of March 31,
2005, TEP's common equity equaled 29.6% of total capitalization (excluding
capital lease obligations).
UniSource Energy expects to borrow the entire $90 million available under
its term loan facility by June 30, 2005 and use the loan proceeds to make a
capital contribution to TEP. It is anticipated that this capital contribution,
together with the proceeds TEP received from the inter-company note repayment in
March 2005 and any additional capital contributions to TEP from the proceeds of
UniSource Energy's issuance of convertible senior notes in March 2005, will be
used by TEP to retire or repurchase $225 million of its outstanding debt
obligations. After these transactions are complete, TEP expects its common
equity ratio to equal 40% of total capitalization (excluding capital leases).
In addition to the dividend limitations noted above, the Federal Power Act
states that dividends shall not be paid out of funds properly included in
capital accounts. Although the terms of the Federal Power Act are unclear, we
believe that there is a reasonable basis to pay dividends from current year
earnings.
43
UNS GAS
RESULTS OF OPERATIONS
---------------------
UNS Gas reported net income of $4 million in both the first quarters of
2005 and 2004.
As of March 31, 2005, UNS Gas had approximately 135,600 retail customers, a
5% increase from last year. The table below shows UNS Gas' therm sales and
revenues for the first quarters of 2005 and 2004.
SALES REVENUE
THREE MONTHS ENDED MARCH 31, 2005 2004 2005 2004
-------------------------------------- --------------------------- ---------------------------
- Millions of Therms - - Millions of Dollars -
RETAIL THERM SALES:
Residential 30 31 $ 30 $ 31
Commercial 10 11 9 10
Industrial 1 1 1 1
Public Authorities 3 3 3 2
-------------------------------------- ---------- ---------------- ------------ --------------
TOTAL RETAIL THERM SALES 44 46 43 44
Transport - - 1 1
Negotiated Sales Program (NSP) 5 6 3 4
-------------------------------------- ---------- ---------------- ------------ --------------
TOTAL THERM SALES 49 52 $ 47 $ 49
====================================== ========== ================ ============ ==============
Retail therm sales were 4% lower in the first quarter of 2005 compared with
the same period last year due to mild winter weather. Retail revenues fell $1
million, or 2%, in the first three months of 2005.
Through a Negotiated Sales Program (NSP) approved by the ACC, UNS Gas
supplies natural gas to some of its large transportation customers.
Approximately one half of the margin earned on these NSP sales is retained by
UNS Gas, while the remainder benefits retail customers through a credit to the
Purchased Gas Adjustor (PGA) mechanism which reduces the gas commodity price.
See Factors Affecting Results of Operations, Rates and Regulation, Energy Cost
Adjustment Mechanism, below.
The table below provides summary financial information for UNS Gas.
THREE MONTHS ENDED MARCH 31, 2005 2004
------------------------------------------------- ---------------------------
- Millions of Dollars -
Gas Revenues $ 46 $49
Other Revenues 1 -
------------------------------------------------- ------------ --------------
Total Operating Revenues 47 49
------------------------------------------------- ------------ --------------
Purchased Gas Expense 31 32
------------------------------------------------- ------------ --------------
Other Operations and Maintenance Expense 6 6
Depreciation and Amortization 1 1
Taxes other than Income Taxes 1 1
------------------------------------------------- ------------ --------------
Total Other Operating Expenses 8 8
------------------------------------------------- ------------ --------------
Operating Income 8 9
------------------------------------------------- ------------ --------------
Total Interest Expense 1 2
Income Tax Expense 3 3
------------------------------------------------- ------------ --------------
NET INCOME $ 4 $ 4
================================================= ============ ==============
44
FACTORS AFFECTING RESULTS OF OPERATIONS
---------------------------------------
RATES AND REGULATION
ENERGY COST ADJUSTMENT MECHANISM
UNS Gas' retail rates include a PGA mechanism intended to address the
volatility of natural gas prices and allows UNS Gas to recover its costs through
a price adjustor. The PGA charge may be changed monthly based on an ACC approved
mechanism that compares the twelve-month rolling average gas cost to the base
cost of gas, subject to limitations on how much the price per therm may change
in a twelve month period. The difference between the actual cost of UNS Gas' gas
supplies and transportation contracts and that currently allowed by the ACC are
deferred and recovered or repaid through the PGA mechanism. When under or over
recovery trigger points are met, UNS Gas may request a PGA surcharge or
surcredit with the goal of collecting or returning the amount deferred from or
to customers over a twelve month period.
In January 2005, UNS Gas requested the ACC approve a PGA surcharge of $0.06
per therm to begin April 1, 2005 and end one year later, to recover its excess
gas purchase costs. The previous PGA surcharge of $0.1155 per therm took effect
October 1, 2003 and ended November 1, 2004. On March 31, 2005, the ACC approved
a PGA surcharge of $0.03 per therm beginning April 11, 2005 and to last until
the excess gas purchase costs are fully recovered. Based on current and
projected gas prices and the rates currently in effect, we do not expect the PGA
balance at March 31, 2005, to be fully recovered until 2008.
LIQUIDITY AND CAPITAL RESOURCES
-------------------------------
UNS Gas' capital requirements consist primarily of capital expenditures. In
the first three months of 2005, capital expenditures were $7 million. During
2005, UNS Gas expects to generate sufficient internal cash flows to fund its
operating activities and a portion of its construction expenditures. Remaining
cash needed for construction expenditures is expected to be obtained through a
combination of the equity investment from UniSource Energy and borrowings under
a revolving credit facility that was established in April 2005. See Credit
Agreement, below.
In January 2005, UNS Gas established a short-term inter-company promissory
note to UniSource Energy, by which it may borrow up to $10 million for general
corporate purposes. On March 10, 2005, UniSource Energy contributed an
additional $6 million in equity to UNS Gas. On March 10, 2005, UNS Gas repaid
the $6 million outstanding on this note from the proceeds of the $6 million
equity contribution.
The table below provides summary information for operating cash flow and
capital expenditures for the first three months of 2005 and 2004.
THREE MONTHS ENDED MARCH 31, 2005 2004
----------------------------------------- -------------------------------
- Millions of Dollars -
Net Cash Flows - Operating Activities $ 6 $ 11
Capital Expenditures 7 4
----------------------------------------- ---------------- --------------
UNS Gas/UNS Electric Revolver
-----------------------------
On April 15, 2005, UNS Gas and UNS Electric, each as a borrower, and UES,
as guarantor, entered into a $40 million three-year unsecured revolving credit
agreement with a group of lenders (the UNS Gas/UNS Electric Revolver). Either
borrower may borrow up to a maximum of $30 million; however, the total combined
amount borrowed can not exceed $40 million. The UNS Gas/UNS Electric Revolver
expires on April 15, 2008. The proceeds of any loans or letters of credit are
expected to be used for general corporate purposes.
UNS Gas is only liable for UNS Gas' borrowings, and similarly, UNS Electric
is only liable for UNS Electric's borrowings under the UNS Electric/UNS Gas
Revolver. UES guarantees the obligations of both UNS Gas and UNS Electric.
Interest is payable at LIBOR plus 1.50%; or at a rate equal to the sum of:
(1) the greater of the federal funds rate plus 1/2 of 1% or a bank reference
rate, and (2) 0.50%.
45
The UNS Gas/UNS Electric Revolver contains a number of covenants which
restrict additional indebtedness, liens, mergers and sales of assets. The UNS
Gas/UNS Electric Revolver also contains several financial covenants including:
(1) a maximum consolidated leverage ratio and (2) a minimum cash flow to
interest coverage ratio, in each case determined for each borrower on a
standalone basis.
The UNS Gas/UNS Electric Revolver may become immediately payable if an
event of default occurs. An event of default includes failure to make required
payments under the UNS Gas/UNS Electric Revolver; certain change in control
transactions or certain bankruptcy events of UNS Gas or UNS Electric; or failure
of UES, UNS Gas or UNS Electric to make payments or default on debt greater than
$4 million.
UNS Gas and UNS Electric expect to draw upon the UNS Gas/UNS Electric
Revolver from time to time primarily for seasonal working capital purposes.
Senior Unsecured Notes
----------------------
On August 11, 2003, UNS Gas issued a total of $100 million of aggregate
principal amount of senior unsecured notes in a private placement consisting of
$50 million of 6.23% Notes due in 2011 and $50 million of 6.23% Notes due in
2015. Proceeds from the note issuance were paid to Citizens to purchase the
Arizona gas system assets. The notes are guaranteed by UES.
The note purchase agreement for UNS Gas contains certain restrictive
covenants, including restrictions on transactions with affiliates, mergers,
liens to secure indebtedness, restricted payments, incurrence of indebtedness,
and minimum net worth. Consolidated Net Worth, as defined by the note purchase
agreement for UNS Gas, is approximately equal to the balance sheet line item,
Common Stock Equity. The table below outlines the actual and required minimum
net worth levels of UES and UNS Gas at March 31, 2005.
REQUIRED MINIMUM
COMPANY NET WORTH ACTUAL NET WORTH
--------------------- --------------------------------------------------
- Millions of Dollars -
UES $ 50 $114
UNS Gas 43 69
--------------------- ---------------------------- ---------------------
The incurrence of indebtedness covenant requires UNS Gas to meet certain
tests before additional indebtedness may be incurred. These tests include:
o A ratio of Consolidated Long-Term Debt to Consolidated Total
Capitalization of no greater than 0.65 to 1.00.
o An Interest Coverage Ratio (a measure of cash flow to cover interest
expense) of at least 2.50 to 1.00.
However, UNS Gas may, without meeting these tests, refinance indebtedness
and incur short-term debt in an amount not to exceed $7 million. UNS Gas may not
declare or make distributions or dividends (restricted payments) on its common
stock unless (a) immediately after giving effect to such action no default or
event of default would exist under its note purchase agreement and (b)
immediately after giving effect to such action, it would be permitted to incur
an additional dollar of indebtedness under the debt incurrence test. As of March
31, 2005, UNS Gas was in compliance with the terms of its note purchase
agreement.
The senior unsecured notes may become due earlier than the maturity date
upon the occurrence and continuance of an event of default under the note
purchase agreement. Events of default under the note purchase agreement include:
failure to make payments required by the note purchase agreement; certain events
of bankruptcy or similar liquidation or reorganization proceedings; and a change
of control of UES or UNS Gas.
In addition, an event of default may occur in the following situations: UNS
Gas, UES or UNS Electric defaults on any payments required of certain
indebtedness in an aggregate principal amount of at least $4 million; any such
indebtedness becomes due or is called for payment prior to its scheduled payment
date; or if there is a default in the compliance with the other terms of such
indebtedness and, as a result of such default, such indebtedness has become due
and payable, prior to its scheduled payment date.
46
DIVIDENDS ON COMMON STOCK
The Citizens Settlement Agreement, as approved by the ACC, limits dividends
payable by UNS Gas to 75% of earnings until the ratio of common equity to total
capitalization reaches 40%. An equity investment of $6 million was made to UNS
Gas by UniSource Energy on March 10, 2005. At March 31, 2005, the ratio of
common equity to total capitalization for UNS Gas was 41%.
The note purchase agreement for UNS Gas contains restrictive covenants
including restrictions on dividends. According to the note purchase agreements
UNS Gas may not declare or make distributions or dividends (restricted payments)
on its common stock unless, (a) immediately after giving effect to such action
no default or event of default would exist under its note purchase agreement and
(b) immediately after giving effect to such action, it would be permitted to
incur an additional dollar of indebtedness under the debt incurrence test. It is
unlikely, however, that UNS Gas will pay dividends in the next five years due to
expected cash requirements for capital expenditures.
UNS ELECTRIC
RESULTS OF OPERATIONS
---------------------
UNS Electric reported net income of approximately $1 million in the first
quarters of both 2005 and 2004. Similar to TEP's operations, we expect UNS
Electric's operations to be seasonal in nature, with peak energy demand
occurring in the summer months.
As of March 31, 2005, UNS Electric had approximately 86,500 retail
customers, a 5% increase from last year. The table below shows UNS Electric's
kWh sales and revenues for the first quarters of 2005 and 2004.
SALES REVENUE
THREE MONTHS ENDED MARCH 31, 2005 2004 2005 2004
---------------------------------- ------------------------------------- ----------------------------------
- Millions of kWh - - Millions of Dollars -
ELECTRIC RETAIL SALES:
Residential 152 153 $ 16 $ 16
Commercial 122 120 12 12
Industrial 42 43 3 3
Other 1 1 - -
---------------------------------- ----------------- ------------------- ---------------- -----------------
TOTAL ELECTRIC RETAIL SALES 317 317 $ 31 $ 31
================================== ================= =================== ================ =================
Retail kWh sales and revenues were unchanged in the first quarter of 2005
compared with the same period last year. Mild winter weather offset the growth
in retail customers.
47
The table below provides summary financial information for UNS Electric.
THREE MONTHS ENDED MARCH 31, 2005 2004
---------------------------------------------- ---------------------------
- Millions of Dollars -
Electric Revenues $ 31 $ 31
Other Revenues 1 -
---------------------------------------------- ------------ --------------
Total Operating Revenues 32 31
---------------------------------------------- ------------ --------------
Purchased Energy Expense 21 21
---------------------------------------------- ------------ --------------
Other Operations and Maintenance Expense 6 5
Depreciation and Amortization 2 2
Taxes other than Income Taxes 1 1
---------------------------------------------- ------------ --------------
Total Other Operating Expenses 9 8
---------------------------------------------- ------------ --------------
Operating Income 2 2
---------------------------------------------- ------------ --------------
Total Interest Expense 1 1
Income Tax Expense - -
---------------------------------------------- ------------ --------------
NET INCOME $ 1 $ 1
============================================== ============ ==============
FACTORS AFFECTING RESULTS OF OPERATIONS
---------------------------------------
COMPETITION
As required by the ACC order approving UniSource Energy's acquisition of
the Citizens' Arizona gas and electric assets, on November 3, 2003, UNS Electric
filed with the ACC a plan to open its service territories to retail competition
by December 31, 2003. The plan addresses all aspects of implementation. It
includes UNS Electric's unbundled distribution tariffs for both standard offer
customers and customers that choose competitive retail access, as well as Direct
Access and Settlement Fee schedules. UNS Electric's direct access rates for both
transmission and ancillary services will be based upon its FERC Open Access
Transmission Tariff. The plan is subject to review and approval by the ACC. As a
result of the court decisions concerning the ACC's Retail Electric Competition
Rules, we are unable to predict when and how the ACC will address this plan. See
Tucson Electric Power Company, Factors Affecting Results of Operations,
Competition, above for information regarding the recent Arizona Court of Appeals
decision.
RATES AND REGULATION
ENERGY COST ADJUSTMENT MECHANISM
UNS Electric's retail rates include a PPFAC, which allows for a separate
surcharge or surcredit to the base rate for delivered purchased power to collect
or return under or over recovery of costs. The ACC has approved a PPFAC
surcharge of $0.01825 per kWh to recover the cost of the current
full-requirements power supply agreement with PWCC. UNS Electric is required to
enter into negotiations with PWCC to potentially reduce the cost of this
purchased power contract; 90% of any savings from the negotiations is to be
passed on to UNS Electric rate payers.
LIQUIDITY AND CAPITAL RESOURCES
-------------------------------
UNS Electric's capital requirements consist primarily of capital
expenditures. In the first three months of 2005, capital expenditures were $5
million. During 2005, UNS Electric expects to generate sufficient internal cash
flows to fund its operating activities and a portion of its construction
expenditures. Remaining cash needed for construction expenditures is expected to
be obtained through a combination of the equity investment from UniSource Energy
and borrowings under a revolving credit facility that was established in April
2005.
On March 10, 2005, UniSource Energy contributed an additional $4 million in
equity to UNS Electric.
The table below provides summary information for operating cash flow and
capital expenditures for the first quarters of 2005 and 2004.
48
THREE MONTHS ENDED MARCH 31, 2005 2004
------------------------------------------ -------------------------------
- Millions of Dollars -
Net Cash Flows - Operating Activities $ 7 $ 5
Capital Expenditures 5 4
------------------------------------------ ---------------- --------------
UNS Gas/UNS Electric Revolver
-----------------------------
See UNS Gas, Liquidity and Capital Resources, UNS Gas/UNS Electric Revolver
above for description of UNS Electric's unsecured revolving credit agreement.
Senior Unsecured Notes
----------------------
On August 11, 2003, UNS Electric issued $60 million of aggregate principal
amount of 7.61% senior unsecured notes due in 2008. Proceeds from the note
issuance were paid to Citizens to purchase the Arizona electric system assets.
The notes are guaranteed by UES.
The note purchase agreement for UNS Electric contains certain restrictive
covenants, including restrictions on transactions with affiliates, mergers,
liens to secure indebtedness, restricted payments, incurrence of indebtedness,
and minimum net worth. Consolidated Net Worth, as defined by the note purchase
agreement for UNS Electric, is approximately equal to the balance sheet line
item, Common Stock Equity. The table below outlines the actual and required
minimum net worth levels of UES and UNS Electric at March 31, 2005.
REQUIRED MINIMUM
COMPANY NET WORTH ACTUAL NET WORTH
----------------------- ---------------------------------------------------
- Millions of Dollars -
UES $ 50 $ 114
UNS Electric 26 45
----------------------- --------------------------- -----------------------
The incurrence of indebtedness covenant requires UNS Electric to meet
certain tests before additional indebtedness may be incurred. These tests
include:
o A ratio of Consolidated Long-Term Debt to Consolidated Total
Capitalization of no greater than 0.65 to 1.00.
o An Interest Coverage Ratio (a measure of cash flow to cover interest
expense) of at least 2.50 to 1.00.
However, UNS Electric may, without meeting these tests, refinance
indebtedness and incur short-term debt in an amount not to exceed $5 million.
UNS Electric may not declare or make distributions or dividends (restricted
payments) on its common stock unless (a) immediately after giving effect to such
action no default or event of default would exist under its note purchase
agreement and (b) immediately after giving effect to such action, it would be
permitted to incur an additional dollar of indebtedness under the debt
incurrence test. As of March 31, 2005, UNS Electric was in compliance with the
terms of the note purchase agreement.
The senior unsecured notes may become due earlier than the maturity date
upon the occurrence and continuance of an event of default under the note
purchase agreement. Events of default under the note purchase agreement include:
failure to make payments required by the note purchase agreement; certain events
of bankruptcy or similar liquidation or reorganization proceedings; and a change
of control of UES or UNS Electric.
In addition, an event of default may occur in the following situations: UNS
Electric, UES or UNS Gas defaults on any payments required of certain
indebtedness in an aggregate principal amount of at least $4 million; any such
indebtedness becomes due or is called for payment prior to its scheduled payment
date; or if there is a default in the compliance with the other terms of such
indebtedness and, as a result of such default, such indebtedness has become due
and payable, prior to its scheduled payment date.
DIVIDENDS ON COMMON STOCK
The Citizens Settlement Agreement, as approved by the ACC, limits dividends
payable by UNS Electric to 75% of earnings until the ratio of common equity to
total capitalization reaches 40%. A $4 million equity investment from UniSource
Energy to UNS Electric was made on March 10, 2005. At March 31, 2005, the ratio
of common equity to total capitalization for UNS Electric was 43%.
49
The note purchase agreement for UNS Electric contains restrictive covenants
including restrictions on dividends. According to the note purchase agreements
UNS Electric may not declare or make distributions or dividends (restricted
payments) on its common stock unless, (a) immediately after giving effect to
such action no default or event of default would exist under its note purchase
agreement and (b) immediately after giving effect to such action, it would be
permitted to incur an additional dollar of indebtedness under the debt
incurrence test. It is unlikely, however, that UNS Electric will pay dividends
in the next five years due to expected cash requirements for capital
expenditures.
GLOBAL SOLAR ENERGY, INC.
RESULTS OF OPERATIONS
---------------------
UniSource Energy accounts for Global Solar under the consolidation method
and recognizes 100% of Global Solar's losses. Global Solar recognizes expense
when funding is used for research, development and administrative costs. The
table below provides a breakdown of the net losses recorded by Global Solar:
THREE MONTHS ENDED MARCH 31, 2005 2004
------------------------------------------------------- ----------------------------
- Millions of Dollars -
Global Solar
Other Revenues $ - $ 1
Research & Development Contract Expenses & Losses - (1)
Depreciation & Amortization Expense (1) (1)
Administrative & Other Costs (2) (1)
Income Tax Benefits 1 1
------------------------------------------------------- -------------- -------------
Total Global Solar Net Loss $ (2) $ (1)
======================================================= ============== =============
GLOBAL SOLAR COMMITMENTS
It is our intention for UniSource Energy to cease additional funding of
Global Solar. To that end, Millennium plans to seek additional investors for
Global Solar, or sell all or part of its interest, or a combination of both, to
preserve the value of Global Solar. We anticipate that any operating and capital
funding required to maintain Global Solar in the interim will be provided only
out of existing Millennium cash or cash returns from Millennium investments. We
believe such cash and returns will be adequate for that purpose and to fund
Millennium's remaining commitments to Global Solar. Millennium has been
authorized to fund up to an additional $5 million for capital expenditures and
operations at Global Solar. Millennium funded $1.3 million of this commitment
during the first quarter of 2005. Global Solar has $1 million in commitments to
incur future expenses related to government contracts.
OTHER
RESULTS OF OPERATIONS
---------------------
Other non-reportable segments consist of UniSource Energy parent company
expenses, which includes interest expense related to the convertible note
offering as previously discussed, income and losses from other Millennium
investments, and income and losses from UED. UniSource Energy parent company
expenses include interest on the convertible notes and interest expense (net of
tax) on a note payable from UniSource Energy to TEP. The note payable was repaid
in March 2005.
The table below summarizes the income and losses for the Other
non-reportable segments:
THREE MONTHS ENDED MARCH 31, 2005 2004
--------------------------------------- ------------------------------
- Millions of Dollars -
Other Millennium Investments $ (1) $ 3
UniSource Energy Parent Company (1) (2)
--------------------------------------- -------------- ---------------
Total Other $ (2) $ 1
======================================= ============== ===============
50
OTHER MILLENNIUM INVESTMENTS
Millennium accounts for its investments under the consolidation method and
the equity method. In some cases, Millennium is an investment's sole provider of
funding. When this is the case, Millennium recognizes 100% of an investment's
losses, because as sole provider of funds it bears all of the financial risk. To
the extent that an investment becomes profitable and Millennium has recognized
losses in excess of its percentage ownership, Millennium will recognize 100% of
an investment's net income until Millennium's recognized losses equal its
ownership percentage of losses.
Results from Other Millennium Investments for the three months ended March
31, 2005 include after-tax losses of less than $1 million each from several of
Millennium's other investments.
Results from Other Millennium Investments for the three months ended March
31, 2004 include after-tax gains of $3 million from Haddington and $1 million
from MicroSat. These gains were partially offset by after-tax losses of less
than $1 million each from several of Millennium's other investments.
CONSOLIDATED MILLENNIUM INVESTMENTS AND COMMITMENTS
Millennium funded $1.5 million in debt commitments to Infinite Power
Solutions, Inc. (IPS) during 2004, and Dow Corning Enterprises, Inc. (DCEI) also
funded its $1 million commitment. Pursuant to the terms of amended promissory
notes with IPS, Millennium and DCEI have the right to convert at any time the
outstanding debt amounts to equity ownership. DCEI holds warrants to purchase
additional preferred shares of IPS that if exercised, could result in
Millennium's ownership of IPS being reduced to as low as 59%. Millennium and
DCEI are continuing to evaluate the ongoing viability of IPS. In the event the
operations of IPS are discontinued, Millennium would recognize an after-tax loss
of less than $1 million.
In April 2005, Millennium, through Advanced Energy Technologies, Inc.,
entered into a transaction with SpringWorks, LLC (SpringWorks) (the investment
arm of Petters Group Worldwide, LLC), Symmorphix, Inc. (Symmorphix) (a
subsidiary of SpringWorks), DCEI, and IPS that included the formation of a new
Delaware corporation, Battco, Inc. (Battco), intended to carry on the current
business of IPS. As its contribution to the transaction, IPS transferred
substantially all of its assets to Battco in exchange for five million shares of
Battco common stock. Symmorphix contributed a royalty-free license to its
technologies and will provide Battco with development work and equipment at
discounted rates, also in exchange for five million shares of Battco common
stock. The transaction further contemplates that SpringWorks, Millennium and
DCEI will contribute a combined total of approximately $9 million to a
subsequent round of Battco preferred stock financing, contingent on the close of
the preferred financing. Battco expects to raise up to $25 million in preferred
stock financing, $16 million of which will be from additional investors.
Millennium committed to fund $3.3 million of the $9 million, of which $0.4
million has already been funded as a secured convertible loan, which is intended
to be converted to shares of Battco preferred stock at the close of the $25
million financing. The remainder of the preferred stock financing will come from
outside investors.
MEG is in the process of winding down its activities and does not expect to
engage in any new activities after 2005. Millennium is in the process of selling
its remaining interest in Nations Energy Corporation (Nations Energy).
Millennium's remaining commitments for other Millennium investments are $4
million to Haddington and $3 million to Valley Ventures.
It is our intention for UniSource Energy to cease making capital
contributions to Millennium. We anticipate that the funding required to fund
Millennium's remaining commitments will be provided only out of existing
Millennium cash or cash returns from Millennium investments. We believe such
cash and returns will be adequate for that purpose and to fund Millennium's
remaining commitments.
CRITICAL ACCOUNTING ESTIMATES
-----------------------------
In preparing financial statements under Generally Accepted Accounting
Principles (GAAP), management exercises judgment in the selection and
application of accounting principles, including making estimates and
assumptions. UniSource Energy and TEP consider Critical Accounting Estimates to
be those that could result in materially different financial statement results
if our assumptions regarding application of accounting principles were
different. UniSource Energy and TEP describe their Critical Accounting Estimates
below. Other significant accounting policies and recently issued accounting
standards are discussed in the 2004 Annual Report on Form 10-K, Note 1 of Notes
51
to Consolidated Financial Statements - Nature of Operations and Summary of
Significant Accounting Estimates.
ACCOUNTING FOR RATE REGULATION
TEP, UNS Gas and UNS Electric generally use the same accounting policies
and practices used by unregulated companies for financial reporting under GAAP.
However, sometimes these principles, such as the Financial Accounting Standards
Board's (FASB) Statement of Financial Accounting Standards No. 71, Accounting
for the Effects of Certain Types of Regulation (FAS 71), require special
accounting treatment for regulated companies to show the effect of regulation.
For example, in setting TEP, UNS Gas and UNS Electric's retail rates, the ACC
may not allow TEP, UNS Gas or UNS Electric to currently charge their customers
to recover certain expenses, but instead may require that these expenses be
charged to customers in the future. In this situation, FAS 71 requires that TEP,
UNS Gas and UNS Electric defer these items and show them as regulatory assets on
the balance sheet until TEP, UNS Gas and UNS Electric are allowed to charge
their customers. TEP, UNS Gas and UNS Electric then amortize these items as
expense to the income statement as these charges are recovered from customers.
Similarly, certain revenue items may be deferred as regulatory liabilities,
which are also eventually amortized to the income statement as rates to
customers are reduced.
The conditions a regulated company must satisfy to apply the accounting
policies and practices of FAS 71 include:
o an independent regulator sets rates;
o the regulator sets the rates to recover specific costs of delivering
service; and
o the service territory lacks competitive pressures to reduce rates
below the rates set by the regulator.
TEP
In November 1999, upon approval by the ACC of the TEP Settlement Agreement
relating to recovery of TEP's transition costs and standard retail rates, TEP
discontinued application of FAS 71 to its generation operations. TEP's
transmission and distribution regulatory assets, net of regulatory liabilities,
totaled $213 million at March 31, 2005, $24 million of which is not presently
included in the rate base and consequently is not earning a return on
investment. TEP's transmission and distribution regulatory assets, net of
regulatory liabilities, totaled $225 million at December 31, 2004.
TEP continues to apply FAS 71 to its regulated operations, which include
the transmission and distribution portions of its business. TEP regularly
assesses whether it can continue to apply FAS 71 to these operations. If TEP
stopped applying FAS 71 to its remaining regulated operations, it would write
off the related balances of its regulatory assets as an expense and its
regulatory liabilities as income on its income statement. Based on the
regulatory asset balances, net of regulatory liabilities, at March 31, 2005, if
TEP had stopped applying FAS 71 to its remaining regulated operations, it would
have recorded an extraordinary after-tax loss of approximately $129 million.
While regulatory orders and market conditions may affect cash flows, TEP's cash
flows would not be affected if it stopped applying FAS 71 unless a regulatory
order limited its ability to recover the cost of its regulatory assets.
UNS GAS AND UNS ELECTRIC
UNS Gas and UNS Electric's regulatory liabilities, net of regulatory
assets, collectively totaled $5 million at March 31, 2005 and $4 million at
December 31, 2004. UNS Gas and UNS Electric's regulatory assets and liabilities
are included in rate base and consequently are earning a return on investment.
If UNS Gas and UNS Electric stopped applying FAS 71 to their regulated
operations, they would write off the related balances of regulatory assets as an
expense and regulatory liabilities as income on their income statements. Based
on the balances of regulatory liabilities and assets at March 31, 2005, if UNS
Gas and UNS Electric had stopped applying FAS 71 to their regulated operations,
they would have collectively recorded an extraordinary after-tax gain of $3
million. UNS Gas and UNS Electric's cash flows would not be affected if they
stopped applying FAS 71 unless a regulatory order limited their ability to
recover the cost of their regulatory assets.
ACCOUNTING FOR ASSET RETIREMENT OBLIGATIONS
FAS 143, issued by the FASB in June 2001, requires entities to record the
fair value of a liability for a legal obligation to retire an asset in the
period in which the liability is incurred. A legal obligation is a liability
that a party is required to settle as a result of an existing or enacted law,
statute, ordinance or contract. When the liability is initially recorded, the
entity should capitalize a cost by increasing the carrying amount of the related
long-lived asset. Over time, the liability is adjusted to its present value by
52
recognizing accretion expense as an operating expense in the income statement
each period, and the capitalized cost is depreciated over the useful life of the
related asset. Upon settlement of the liability, an entity either settles the
obligation for its recorded amount or incurs a gain or loss if the actual costs
differ from the recorded amount.
TEP
Prior to adopting FAS 143, costs for final removal of all owned generation
facilities were accrued as an additional component of depreciation expense.
Under FAS 143, only the costs to remove an asset with legally binding retirement
obligations will be accrued over time through accretion of the asset retirement
obligation and depreciation of the capitalized asset retirement cost.
TEP has identified legal obligations to retire generation plant assets
specified in land leases for its jointly-owned Navajo and Four Corners
Generating Stations. The land on which these stations reside is leased from the
Navajo Nation. The provisions of the leases require the lessees to remove the
facilities upon request of the Navajo Nation at the expiration of the leases.
TEP also has certain environmental obligations at the San Juan Generating
Station. TEP has estimated that its share of the cost to remove the Navajo and
Four Corners facilities and settle the San Juan environmental obligations will
be approximately $38 million at the date of retirement. No other legal
obligations to retire generation plant assets were identified.
On November 12, 2004, TEP, Phelps Dodge Energy Services, LLC and PNM
Resources, Inc. each purchased from Duke Energy North America, LLC a one-third
interest in a limited liability company which owns the partially constructed
natural gas-fired Luna Energy Facility (Luna) in southern New Mexico. Luna is
designed as a 570-MW combined cycle plant and is expected to be operational by
the summer of 2006. The new owners assumed asset retirement obligations to
remove certain piping and evaporation ponds and to restore the ground to its
original condition. TEP has estimated its share to settle the obligations will
be approximately $2 million at the date of retirement.
TEP has various transmission and distribution lines that operate under land
leases and rights of way that contain end dates and restorative clauses. TEP
operates its transmission and distribution lines as if they will be operated in
perpetuity and would continue to be used or sold without land remediation. As a
result, TEP is not recognizing the costs of final removal of the transmission
and distribution lines in the financial statements. As of March 31, 2005, TEP
had accrued $69 million for the net cost of removal for the interim retirements
from its transmission, distribution and general plant. As of December 31, 2004,
TEP had accrued $67 million for these removal costs. The amount is recorded as a
regulatory liability.
Amounts recorded under FAS 143 are subject to various assumptions and
determinations, such as determining whether a legal obligation exists to remove
assets, estimating the fair value of the costs of removal, estimating when final
removal will occur, and the credit-adjusted risk-free interest rates to be used
to discount future liabilities. Changes that may arise over time with regard to
these assumptions and determinations will change amounts recorded in the future
as expense for asset retirement obligations.
If TEP retires any asset at the end of its useful life, without a legal
obligation to do so, it will record retirement costs at that time as incurred or
accrued. TEP does not believe that the adoption of FAS 143 will result in any
change in retail rates since all matters relating to the rate-making treatment
of TEP's generating assets have been determined pursuant to the TEP Settlement
Agreement.
UES
UES has various transmission and distribution lines that operate under land
leases and rights of way that contain end dates and restorative clauses. UES
operates its transmission and distribution lines as if they will be operated in
perpetuity and would continue to be used or sold without land remediation. As a
result, UES is not recognizing the cost of final removal of the transmission and
distribution lines in the financial statements. UES had accrued $2 million as of
March 31, 2005 and as of December 31, 2004, for the net cost of removal for
interim retirements from its transmission, distribution and general plant. The
amount is recorded as a regulatory liability.
PENSION AND OTHER POST RETIREMENT BENEFIT PLAN ASSUMPTIONS
We record plan assets, obligations, and expenses related to pension and
other postretirement benefit plans based on actuarial valuations. These
valuations include key assumptions on discount rates, expected returns on plan
assets, compensation increases and health care cost trend rates. These actuarial
53
assumptions are reviewed annually and modified as appropriate. The effect of
modifications is generally recorded or amortized over future periods. We believe
that the assumptions used in recording obligations under the plans are
reasonable based on prior experience, market conditions and the advice of plan
actuaries.
TEP
TEP discounted its future pension plan obligations at December 31, 2004
using rates of 6.1% for its Salaried and Union Plans and 6.0% for its Excess
Benefit Plan. The discount rate used at December 31, 2003 was 6.25% for all
plans. TEP discounted its other postretirement plan obligations using a rate of
5.9% at December 31, 2004, compared with 5.5% at December 31, 2003. TEP
determines the discount rate annually based on the rates currently available on
high-quality, long-term bonds. TEP looks to bonds that receive one of the two
highest ratings given by a recognized rating agency whose future cash flows
match the timing and amount of expected future benefit payments.
The pension liability and future pension expense both increase as the
discount rate is reduced. A decrease in the discount rate results in an increase
in the Projected Benefit Obligation (PBO) and the service cost component of
pension expense. Additionally, the recognized actuarial loss is significantly
impacted by a reduction in the discount rate. Since the PBO increases with the
decrease in discount rate, the obligation is that much larger than would
normally occur due to normal growth of the plan. This leads to an actuarial loss
(or a greater actuarial loss than would occur in the absence of the discount
rate change), which is amortized over future periods leading to a greater
expense. The resulting change in the interest cost component of pension expense
is dependent on the effect that the change in the discount rate has on the PBO
and will vary based on employee demographics. The effect of the lower rate used
to calculate the interest cost is offset to some degree by a larger obligation.
The relative magnitude of these two changes determines whether interest cost
will increase or decrease. For TEP's pension plans, a 25 basis point decrease in
the discount rate would increase the accumulated benefit obligation (ABO) by
approximately $5 million and the related plan expense for 2005 by approximately
$1 million. A similar increase in the discount rate would decrease the ABO by
approximately $5 million and the related plan expense for 2005 by approximately
$1 million. For TEP's plan for other postretirement benefits, a 25 basis point
change in the discount rate would increase or decrease the accumulated
postretirement benefit obligation (APBO) by approximately $2 million. A 25 basis
point change in the discount rate would not have a significant impact on the
related plan expense for 2005.
TEP calculates the market-related value of plan assets using the fair value
of plan assets on the measurement date. TEP assumed that its plans' assets would
generate a long-term rate of return of 8.5% at December 31, 2004 and 8.75% at
December 31, 2003. In establishing its assumption as to the expected return on
plan assets, TEP reviews the plans' asset allocation and develops return
assumptions for each asset class based on advice from an investment consultant
and the plans' actuary that includes both historical performance analysis and
forward looking views of the financial markets. Pension expense increases as the
expected rate of return on plan assets decreases. A 25 basis point change in the
expected return on plan assets would not have a significant impact on pension
expense for 2005.
TEP used an initial health care cost trend rate of 11.0% in valuing its
postretirement benefit obligation at December 31, 2004. This rate reflects both
market conditions and the plan's experience. Assumed health care cost trend
rates have a significant effect on the amounts reported for health care plans. A
1% increase in assumed health care cost trend rates would increase the
postretirement benefit obligation by approximately $5 million and the related
plan expense by approximately $1 million. A similar decrease in assumed health
care cost trend rates would decrease the postretirement benefit obligation by
approximately $4 million and the related plan expense by less than $1 million.
TEP recorded a minimum pension liability in Other Comprehensive Income of
approximately $20 million at December 31, 2004, compared with $3 million at
December 31, 2003. This increase resulted primarily from changes in actuarial
assumptions including revised retirements rates, updated mortality rates and a
reduction in the assumed discount rate.
Based on the above assumptions, TEP will record pension expense of
approximately $10 million and other postretirement benefit expense of $7 million
ratably throughout 2005. TEP will make required pension plan contributions of $6
million in 2005. TEP's other postretirement benefit plan is not funded. TEP
expects to make benefit payments to retirees under the postretirement benefit
plan of approximately $3 million in 2005.
54
UNS GAS AND UNS ELECTRIC
Concurrent with the acquisition of the Arizona gas and electric system
assets from Citizens on August 11, 2003, UES established a pension plan for
substantially all employees of UNS Gas and UNS Electric. UES did not assume the
pension obligation for employees' years of service with Citizens.
UES discounted its future pension plan obligations using a rate of 6.1% at
December 31, 2004 and 6.25% at December 31, 2003. For UES' pension plan, a 25
basis point change in the discount rate would have minimal effect on either the
ABO or the related pension expense. UES recorded a minimum pension liability and
an offsetting Intangible Asset of less than $1 million at December 31, 2004 and
approximately $1 million at December 31, 2003. UES will record pension expense
of $1 million in 2005. UES will make a pension plan contribution of $1 million
in 2005.
On the acquisition date, UES assumed the obligation to provide
postretirement benefits for a small population of former Citizens employees,
both active and retired. The plan is not funded. UES discounted its other
postretirement plan obligations using a rate of 5.9% at December 31, 2004,
compared with 5.5% at December 31, 2003. Postretirement medical benefit expenses
are insignificant to UES' operations.
ACCOUNTING FOR DERIVATIVE INSTRUMENTS, TRADING ACTIVITIES AND
HEDGING ACTIVITIES
A derivative financial instrument or other contract derives its value from
another investment or designated benchmark. TEP enters into forward contracts to
purchase or sell a specified amount of capacity or energy at a specified price
over a given period of time, typically for one month, three months, or one year,
within established limits to take advantage of favorable market opportunities.
In general, TEP enters into forward purchase contracts when market conditions
provide the opportunity to purchase energy for its load at prices that are below
the marginal cost of its supply resources or to supplement its own resources
(e.g., during plant outages and summer peaking periods). TEP enters into forward
sales contracts when it forecasts that it has excess supply and the market price
of energy exceeds its marginal cost. The majority of TEP's forward contracts are
considered to be normal purchases and sales and, therefore, are not required to
be marked to market. However, some of these forward contracts are considered to
be derivatives, which TEP marks to market by recording unrealized gains and
losses and adjusting the related assets and liabilities on a monthly basis to
reflect the market prices at the end of the month.
TEP has a natural gas supply agreement under which it purchases all of its
gas requirements at spot market prices from Southwest Gas Corporation (SWG). TEP
also has agreements to purchase power that are priced using spot market gas
prices. These contracts meet the definition of normal purchases and are not
required to be marked to market. During 2004 and early 2005, in an effort to
minimize price risk on these purchases, TEP entered into commodity price swap
agreements under which TEP purchases gas at fixed prices and simultaneously
sells gas at spot market prices. The spot market price in the swap agreements is
tied to the same index as the purchases under the SWG and purchased power
contracts. These swap agreements, which expire during the summer months through
2007, were entered into with the goal of locking in fixed prices on at least 45%
and not more than 80% of TEP's expected summer monthly gas risk prior to
entering into the month. The swap agreements are marked to market on a monthly
basis; however, since the agreements satisfy the requirements for cash flow
hedge accounting, the unrealized gains and losses are recorded in Other
Comprehensive Income, a component of Common Stock Equity, rather than being
reflected in the income statement. As the gains and losses on these cash flow
hedges are realized, a reclassification adjustment is recorded in Other
Comprehensive Income for realized gains and losses that are included in Net
Income.
TEP manages the risk of counterparty default by performing financial credit
reviews, setting limits, monitoring exposures, requiring collateral when needed,
and using a standardized agreement which allows for the netting of current
period exposures to and from a single counterparty.
UNS Gas and UNS Electric do not currently have any contracts that are
required to be marked to market. UNS Gas does have a natural gas supply and
management agreement under which it purchases substantially all of its gas
requirements at market prices from BP Energy Company (BP). However, the contract
terms allow UNS Gas to lock in fixed prices on a portion of its gas purchases by
entering into fixed price forward contracts with BP at various times during the
year. This enables UNS Gas to provide more stable prices to its customers. These
purchases are made up to three years in advance with the goal of locking in
fixed prices on at least 45% and not more than 80% of the expected monthly gas
consumption prior to entering into the month. These forward contracts, as well
55
as the main gas supply contract, meet the definition of normal purchases and
therefore are not required to be marked to market.
MEG, a wholly-owned subsidiary of Millennium, enters into swap agreements,
options and forward contracts relating to Emissions Allowances and coal. MEG
marks its trading contracts to market by recording unrealized gains and losses
and adjusting the related assets and liabilities on a monthly basis to reflect
the market prices at the end of the month. In accordance with UniSource Energy's
intention to cease making capital contributions to Millennium, Millennium has
significantly reduced the holdings and activity of MEG. MEG is in the process of
winding down its activities and will not engage in any new activities after
2005.
The market prices used to determine fair values for TEP and MEG's
derivative instruments at March 31, 2005 are estimated based on various factors
including broker quotes, exchange prices, over the counter prices and time
value. For TEP's forward power contracts, a 10% decrease in market prices would
result in a decrease in unrealized gains of less than $1 million, while a 10%
increase in market prices would result in an increase in unrealized gains of
less than $1 million. For TEP's gas swap agreements, a 10% decrease in market
prices would result in a $4 million decrease in unrealized gains reported in
Other Comprehensive Income, while a 10% increase in market prices would result
in a $4 million increase in unrealized gains reported in Other Comprehensive
Income. For MEG's remaining trading contracts, a 10% decrease in market prices
would result in an increase in unrealized losses of less than $1 million, while
a 10% increase in market prices would result in a decrease in unrealized losses
of less than $1 million.
Because of the complexity of derivatives, the FASB established a
Derivatives Implementation Group (DIG). To date, the DIG has issued more than
100 interpretations to provide guidance in applying Statement of Financial
Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging
Activities (FAS 133). As the DIG or the FASB continues to issue interpretations,
TEP, UNS Gas and UNS Electric may change the conclusions they have reached and,
as a result, the accounting treatment and financial statement impact could
change in the future.
See Market Risks - Commodity Price Risk in Item 3.
UNBILLED REVENUE - TEP, UNS GAS AND UNS ELECTRIC
TEP's, UNS Gas's and UNS Electric's retail revenues include an estimate of
MWhs/therms delivered but unbilled at the end of each period. Unbilled revenues
are dependent upon a number of factors that require management's judgment
including estimates of retail sales and customer usage patterns. The unbilled
revenue is estimated by comparing the estimated MWhs/therms delivered to the
MWhs/therms billed to TEP, UNS Gas and UNS Electric retail customers. The excess
of estimated MWhs/therms delivered over MWhs/therms billed is then allocated to
the retail customer classes based on estimated usage by each customer class.
TEP, UNS Gas and UNS Electric then record revenue for each customer class based
on the various bill rates for each customer class. Due to the seasonal
fluctuations of TEP's actual load, the unbilled revenue amount increases during
the spring and summer months and decreases during the fall and winter months.
The unbilled revenue amount for UNS Gas sales increases during the fall and
winter months and decreases during the spring and summer months, whereas, the
unbilled revenue amount for UNS Electric sales increases during the spring and
summer months and decreases during the fall and winter months.
PLANT ASSET DEPRECIABLE LIVES - TEP, UNS GAS AND UNS ELECTRIC
We calculate depreciation expense based on our estimate of the useful lives
of our plant assets. The estimated useful lives, and resulting depreciation
rates used to calculate depreciation expense for the transmission and
distribution businesses of TEP, UNS Gas and UNS Electric have been approved by
the ACC in prior rate decisions. Depreciation rates for transmission and
distribution cannot be changed without ACC approval.
The estimated remaining useful lives of TEP's generating facilities are
based on management's best estimate of the economic life of the units. These
estimates are based on engineering estimates, economic analysis, and statistical
analysis of TEP's past experience in maintaining the stations. For 2004,
depreciation expense related to generation assets was $35 million, and our
generation assets are currently depreciated over periods ranging from 23 to 70
years from the original in-service dates.
During the first quarter of 2004, TEP engaged an independent third party to
review the economic estimated useful lives of its owned generating assets in
Springerville, Arizona. TEP then hired a different independent third party to
perform a depreciation study for its generation assets, taking into
56
consideration the newly determined economic useful life for the Springerville
assets, and changes in generation plant life information used by the operators
and other participants of the joint power plants in which TEP participates. As a
result of these analyses, TEP lengthened the useful lives of various generation
assets for periods ranging from 11 to 22 years in July 2004. Consequently,
depreciation rates and the corresponding depreciation expense have been revised
prospectively to reflect the life extensions. The annual impact of these changes
in depreciation rates is a reduction in depreciation expense of $9 million. A
study is currently underway by the operating agent of the San Juan Generating
Station to determine whether San Juan's economic useful life has changed from
previous estimates. If the economic life of San Juan is extended by ten years,
TEP's annual depreciation expense would decrease by an additional $4 million.
DEFERRED TAX VALUATION - TEP AND MILLENNIUM
We record deferred tax liabilities for amounts that will increase income
taxes on future tax returns. We record deferred tax assets for amounts that
could be used to reduce income taxes on future tax returns. We record a
valuation allowance, or reserve, for the deferred tax asset amount that we may
not be able to use on future tax returns. We estimate the valuation allowance
based on our interpretation of the tax rules, prior tax audits, tax planning
strategies, scheduled reversal of deferred tax liabilities, and projected future
taxable income.
At March 31, 2005 and December 31, 2004, UniSource Energy and TEP had a
valuation allowance of $8 million relating to net operating loss (NOL) and
investment tax credit (ITC) carryforward amounts.
Of the $8 million valuation allowance balance at March 31, 2005 and
December 31, 2004, $7 million relates to losses generated by the Millennium
entities. In the future, if UniSource Energy and the Millennium entities
determine that all or a portion of the losses may be used on tax returns, then
UniSource Energy and the Millennium entities would reduce the valuation
allowance and recognize a tax benefit of up to $7 million. The primary factor
that could cause the Millennium entities to recognize a tax benefit would be a
change in expected future taxable income.
The remaining $1 million of valuation allowance balance at March 31, 2005
and December 31, 2004, relates to ITC carryforwards at TEP which may not be
utilized on tax returns prior to their expiration. If in the future UniSource
Energy and TEP determine that it is probable that TEP will not use all or a
portion of additional ITC carryforward amounts, then UniSource Energy and TEP
would record additional valuation allowance and recognize tax expense. The
primary factor that could cause TEP to record additional valuation allowance
would be a change in expected future taxable income.
As of March 31, 2005 and December 31, 2004, UniSource Energy's deferred
income tax assets include $14 million related to unregulated investment losses
of Millennium. TEP's deferred income tax assets include $1 million related to
TEP's unregulated investment losses. These losses have not been reflected on
UniSource Energy's consolidated income tax returns. If UniSource Energy is
unable to recognize such losses through its consolidated income tax return in
the foreseeable future, UniSource Energy and TEP would be required to write off
these deferred tax assets. Millennium intends to restructure its ownership in
two of these investments, Infinite Power Solutions (IPS) and Corporacion Panama
de Energia S.A. (Copesa), in 2005. As a result of these actions, UniSource
Energy expects to liquidate IPS for tax purposes and dispose of its stock
interest in Copesa, both resulting in taxable losses that will be reflected on
UniSource Energy's consolidated income tax return. If these actions, or other
actions resulting in the recognition of the losses for tax purposes, do not
occur, UniSource Energy would be required to eliminate the deferred tax assets
and recognize additional tax expense of $9 million.
NEW ACCOUNTING PRONOUNCEMENTS
-----------------------------
The FASB recently issued the following Statements of Financial Accounting
Standards (FAS), FASB Interpretations (FIN), and FASB Staff Positions (FSP):
o FIN 47, Accounting for Conditional Asset Retirement Obligations,
issued March 2005, provides guidance for a legal obligation to perform
an asset retirement activity in which the timing and (or) method of
settlement are conditional on a future event that may or may not be
within the control of the entity. The obligation to perform the asset
retirement activity is unconditional even though uncertainty exists
about the timing and (or) method of settlement. FIN 47 requires a
liability be recognized for the fair value of a conditional asset
retirement obligation if the fair value can be reasonably estimated.
FIN 47 is required to be applied by December 31, 2005. We are
57
evaluating the impact on our financial position and results of
operations of the adoption of FIN 47.
o FSP FIN 46(R)-5, Implicit Variable Interests under FASB Interpretation
No. 46 (revised December 2003), Consolidation of Variable Interest
Entities, issued March 2005, addresses whether a reporting enterprise
should consider whether it holds an implicit variable interest in a
variable interest entity (VIE) or potential VIE when specific
conditions exist. The guidance in FSP FIN 46(R)-5 was effective April
1, 2005, and did not have a significant impact on our financial
statements.
o FAS 153, Exchanges of Nonmonetary Assets, issued December 2004,
requires nonmonetary exchanges be accounted for at fair value,
recognizing any gains or losses, if their fair value is determinable
within reasonable limits and the transaction has commercial substance.
A nonmonetary exchange has commercial substance if future cash flows
of the entity are expected to change significantly as a result of the
exchange. FAS 153 is effective for nonmonetary asset exchange
transactions occurring in fiscal periods beginning after June 15,
2005. The adoption of FAS 153 is not expected to have a significant
impact on our financial statements.
o FSP FAS 109-1, Application of FASB Statement No. 109, Accounting for
Income Taxes, to the Tax Deduction on Qualified Production Activities
Provided by the American Jobs Creation Act of 2004, issued in December
2004, provides guidance on the application of FAS 109 to the provision
within the American Jobs Creation Act of 2004 that provides a tax
deduction, beginning in 2005, on qualified production activities,
including a company's electric generation activities. Under FSP FAS
109-1, recognition of the tax deduction on qualified production
activities is ordinarily reported in the year it is earned. FSP FAS
109-1 did not have a significant impact on our financial statements in
the first quarter. We are evaluating the impact of FSP FAS 109-1 on
our financial position and results of operations for the remainder of
the year.
o FAS 151, Inventory Costs, issued November 2004, is an amendment of
Accounting Research Bulletin (ARB) No. 43, Chapter 4, Inventory
Pricing. FAS 151 clarifies that abnormal amounts of idle facility
expense, freight, handling costs, and wasted materials (spoilage)
should be recognized as current-period charges. FAS 151 also requires
the allocation of fixed production overheads to inventory based on the
normal capacity of the production facilities. FAS 151 is effective for
inventory costs incurred during fiscal years beginning after June 15,
2005. The adoption of FAS 151 is not expected to have a significant
impact on our financial statements.
In June 2004, the EITF published Issue No. 03-1, The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain Investments (EITF
03-1). EITF 03-1 provides application guidance on impairment of securities
accounted for under FAS 115, Accounting for Certain Investments in Debt and
Equity Securities, and cost method investments and requires certain quantitative
and qualitative disclosures for securities that are impaired at the balance
sheet date but for which an other-than-temporary impairment has not been
recognized. The disclosure requirements are effective for reporting periods
ending after December 31, 2003. The FASB issued FSP EITF Issue 03-1-1, Effective
Date of Paragraphs 10-20 of EITF Issue No. 03-1, The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain Investments in
September 2004 delaying the effective date of the application guidance on
impairment of securities until the final issuance of FSP EITF Issue 03-1-a. As
of May 9, 2005, a final FSP EITF Issue 03-1-a has not been issued. The adoption
of EITF 03-1 is not expected to have a significant impact on our financial
statements.
SAFE HARBOR FOR FORWARD-LOOKING STATEMENTS
------------------------------------------
This Quarterly Report on Form 10-Q contains forward-looking statements as
defined by the Private Securities Litigation Reform Act of 1995. UniSource
Energy and TEP are including the following cautionary statements to make
applicable and take advantage of the safe harbor provisions of the Private
Securities Litigation Reform Act of 1995 for any forward-looking statements made
by or for UniSource Energy or TEP in this Quarterly Report on Form 10-Q.
Forward-looking statements include statements concerning plans, objectives,
goals, strategies, future events or performance and underlying assumptions and
other statements that are not statements of historical facts. Forward-looking
statements may be identified by the use of words such as "anticipates",
"estimates", "expects", "intends", "plans", "predicts", "projects", and similar
expressions. From time to time, we may publish or otherwise make available
forward-looking statements of this nature. All such forward-looking statements,
whether written or oral, and whether made by or on behalf of UniSource Energy or
TEP, are expressly qualified by these cautionary statements and any other
cautionary statements which may accompany the forward-looking statements. In
addition, UniSource Energy and TEP disclaim any obligation to update any
forward-looking statements to reflect events or circumstances after the date of
this report.
Forward-looking statements involve risks and uncertainties, which could
cause actual results or outcomes to differ materially from those expressed in
the forward-looking statements. We express our expectations, beliefs and
projections in good faith and believe them to have a reasonable basis. However,
58
we make no assurances that management's expectations, beliefs or projections
will be achieved or accomplished. We have identified the following important
factors that could cause actual results to differ materially from those
discussed in our forward-looking statements. These may be in addition to other
factors and matters discussed in other parts of this report:
1. Effects of restructuring initiatives in the electric industry and
other energy-related industries.
2. Effects of competition in retail and wholesale energy markets.
3. Changes in economic conditions, demographic patterns and weather
conditions in our retail service areas.
4. Supply and demand conditions in wholesale energy markets, including
volatility in market prices and illiquidity in markets, which are
affected by a variety of factors. These factors include the
availability of generating capacity in the western U.S., including
hydroelectric resources, weather, natural gas prices, the extent of
utility restructuring in various states, transmission constraints,
environmental regulations and cost of compliance, FERC regulation of
wholesale energy markets, and economic conditions in the western U.S.
5. The creditworthiness of the entities with which we transact business
or have transacted business.
6. Changes affecting our cost of providing electrical service including
changes in fuel costs, generating unit operating performance,
scheduled and unscheduled plant outages, interest rates, tax laws,
environmental laws, and the general rate of inflation.
7. Changes in governmental policies and regulatory actions with respect
to financing and rate structures.
8. Changes affecting the cost of competing energy alternatives, including
changes in available generating technologies and changes in the cost
of natural gas.
9. Changes in accounting principles or the application of such principles
to our businesses.
10. Changes in the depreciable lives of our assets.
11. Market conditions and technological changes affecting our unregulated
businesses.
12. Unanticipated changes in future liabilities relating to employee
benefit plans due to changes in market values of retirement plan
assets and health care costs.
13. The outcome of any ongoing or future litigation.
14. Ability to obtain financing through debt and/or equity issuance, which
can be affected by various factors, including interest rate
fluctuations and capital market conditions.
ITEM 3. - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
--------------------------------------------------------------------
The information contained in this Item updates, and should be read in
conjunction with, information included in Part II, Item 7A in UniSource Energy
and TEP's Annual Report on Form 10-K for the year ended December 31, 2004, in
addition to the interim condensed consolidated financial statements and
accompanying notes presented in Items 1 and 2 of this Form 10-Q.
We are exposed to various forms of market risk. Changes in interest rates,
returns on marketable securities, and changes in commodity prices may affect our
future financial results. The market risks resulting from changes in interest
rates and returns on marketable securities have not changed materially from the
market risks reported in the 2004 Annual Report on Form 10-K. For additional
information concerning risk factors, including market risks, see Safe Harbor for
Forward-Looking Statements, above.
RISK MANAGEMENT COMMITTEE
We have a Risk Management Committee responsible for the oversight commodity
price risk and credit risk related to the wholesale energy marketing activities
of TEP, the emissions and coal trading activities of MEG, and the fuel and power
59
procurement activities at TEP and UES. Our Risk Management Committee, which
meets on a quarterly basis and as needed, consists of officers from the finance,
accounting, legal, wholesale marketing, transmission and distribution
operations, and the generation operations departments of UniSource Energy. To
limit TEP's, UES' and MEG's exposure to commodity price risk, the Risk
Management Committee sets trading and hedging policies and limits, which are
reviewed frequently to respond to constantly changing market conditions. To
limit TEP's, UES' and MEG's exposure to credit risk, the Risk Management
Committee reviews counterparty credit exposure, as well as credit policies and
limits.
COMMODITY PRICE RISK
We are exposed to commodity price risk primarily relating to changes in the
market price of electricity, natural gas, coal and Emission Allowances.
TEP
To manage its exposure to energy price risk, TEP enters into forward
contracts to buy or sell energy at a specified price and future delivery period.
Generally, TEP commits to future sales based on expected excess generating
capability, forward prices and generation costs, using a diversified market
approach to provide a balance between long-term, mid-term and spot energy sales.
TEP generally enters into forward purchases during its summer peaking period to
ensure it can meet its load and reserve requirements and account for other
contracts and resource contingencies. TEP also enters into limited forward
purchases and sales to optimize its resource portfolio and take advantage of
locational differences in price. These positions are managed on both a
volumetric and dollar basis and are closely monitored using risk management
policies and procedures overseen by the Risk Management Committee. For example,
the risk management policies provide that TEP should not take a short position
in the third quarter and must have owned generation backing up all forward sales
positions at the time the sale is made. TEP's risk management policies also
restrict entering into forward positions with maturities extending beyond the
end of the next calendar year.
The majority of TEP's forward contracts are considered to be "normal
purchases and sales" of electric energy and are not considered to be derivatives
under FAS 133. TEP records revenues on its "normal sales" and expenses on its
"normal purchases" in the period in which the energy is delivered. From time to
time, however, TEP enters into forward contracts that meet the definition of a
derivative under FAS 133. When TEP has derivative forward contracts, it marks
them to market on a daily basis using actively quoted prices obtained from
brokers for power traded over-the-counter at Palo Verde and at other
southwestern U.S. trading hubs. TEP believes that these broker quotations used
to calculate the mark-to-market values represent accurate measures of the fair
values of TEP's positions, because of the short-term nature of TEP's positions,
as limited by risk management policies, and the liquidity in the short-term
market. As of March 31, 2005, all of TEP's derivative forward contracts were for
settlement within 6 months. To adjust the value of its derivative forward
contracts to fair value on its income statement, TEP recorded net unrealized
gains of $0.4 million and $0.2 million on its income statements for the three
month periods ended March 31, 2005 and 2004, respectively.
TEP is also subject to commodity price risk from changes in the price of
natural gas. TEP typically uses generation from its facilities fueled by natural
gas and purchased power, in addition to energy from its coal-fired facilities,
to meet the summer peak demands of its retail customers and to meet local
reliability needs. Some of these purchased power contracts are price indexed to
natural gas prices. Short-term and spot power purchase prices are also closely
correlated to natural gas prices. Due to its increasing seasonal gas and
purchased power usage, TEP hedges a portion of its total natural gas exposure
from plant fuel, gas-indexed purchase power and spot market purchases with fixed
price contracts for a maximum of three years. TEP purchases its remaining gas
fuel needs and purchased power in the spot and short-term markets.
In 2004, the average price of natural gas was $5.44 per MMBtu, or 11%
higher than 2003, due to low gas storage levels and reductions in gas
production. The increase in the regional supply of gas-generated energy and the
completion of a 500-kV transmission connection, in May 2003, however, allowed
TEP to limit its use of its less efficient gas generation units in favor of more
economical purchases of energy in the wholesale market. TEP's generation output
fueled by natural gas was approximately 427,000 MWh, or 4% of total generation
and purchased power in 2004. During 2004, TEP purchased a total of 1,400,000 MWh
of energy, or 11% of total generation and purchased power, of which
approximately 175,000 MWh were from gas-index priced energy under long-term
purchased power contracts with the remainder being from short-term and spot
power markets.
In the first three months of 2005, the average price of natural gas was
$5.55 per MMBtu, or 11% higher than the same period in 2004. TEP's generation
output fueled by natural gas was approximately 56,000 MWh, or 2% of total
60
generation and purchased power in the first quarter of 2005. During the first
quarter of 2005, TEP purchased a total of 268,000 MWh of energy, or 10% of total
generation and purchased power, of which approximately 29,100 MWh were from
gas-index priced energy under long-term purchased power contracts, with the
remainder being from short-term and spot power markets.
In January 2005, TEP entered into a purchased power agreement with Panda
Gila River. TEP will purchase 50 MW of firm energy during June through September
2005.
TEP entered into two purchased power agreements in 2003 for the period 2003
through 2006. During 2003, TEP purchased approximately 125,000 MWh under these
contracts; energy purchased under these agreements is adjusted for changes in
the price of natural gas.
UES
UES is also subject to commodity price risk, primarily from the changes in
the price of natural gas purchased for its UNS Gas customers. This risk is
mitigated through the PGA mechanism in UNS Gas' retail rates which provides an
adjustment to recover the actual costs of gas and transportation. UNS Gas
further reduces this risk by purchasing forward fixed price contracts for a
portion of its projected gas needs under its Price Stabilization Plan. UNS Gas
purchases between 45% and 80% of its estimated gas needs in this manner.
UNS Electric is not exposed to commodity price risk for its purchase of
electricity as it has a fixed price full-requirements supply agreement with PWCC
through May 2008.
MEG
During the fourth quarter of 2001, MEG began managing and trading Emission
Allowances, coal and related instruments. We manage the market risk of this line
of business by setting notional limits by product, as well as limits to the
potential change in fair market value under a 33% change in price or volatility.
We closely monitor MEG's trading activities, which include swap agreements,
options and forward contracts, using risk management policies and procedures
overseen by the Risk Management Committee. MEG marks its trading positions to
market on a daily basis using actively quoted prices obtained from brokers and
options pricing models for positions that extend through 2007. As of March 31,
2005 and December 31, 2004, the fair value of MEG's trading assets combined with
Emission Allowances it holds in escrow was $56.4 million and $76.5 million,
respectively. The fair value of MEG's trading liabilities was $51 million at
March 31, 2005 and $65 million at December 31, 2004. For the three months ended
March 31, 2005, MEG reflected a $2.2 million unrealized loss and $2.5 million
realized gain on its income statement, compared with an unrealized gain of $1.6
million and a realized loss of $1.4 million for the three months ended March 31,
2004.
Unrealized Gain (Loss) of MEG's Trading Activities
- Millions of Dollars -
Maturity 0 - 6 Maturity 6 - 12 Maturity over Total
Source of Fair Value At March 31, 2005 months months 1 yr. Unrealized Gain
(Loss)
---------------------------------------------------- ----------------- ------------------ --------------- -----------------
Prices actively quoted $ (6.0) $ - $ - $ (6.0)
Prices based on models and other valuation methods 0.1 - 5.4 5.5
---------------------------------------------------- ----------------- ------------------ --------------- -----------------
Total $ (5.9) $ - $ 5.4 $ (0.5)
==================================================== ================= ================== =============== =================
MEG is in the process of winding down its activities and does not expect to
engage in any new activities after 2005.
CREDIT RISK
UniSource Energy is exposed to credit risk in its energy-related marketing
and trading activities related to potential nonperformance by counterparties. We
manage the risk of counterparty default by performing financial credit reviews,
setting limits monitoring exposures, requiring collateral when needed, and using
a standard agreement which allows for the netting of current period exposures to
and from a single counterparty. Despite such mitigation efforts, there is a
potential for defaults by counterparties. In the fourth quarter of 2000 and the
first quarter of 2001, TEP was affected by payment defaults by SCE and PG&E for
amounts owed to the CPX and CISO. In the fourth quarter of 2001, Enron defaulted
on amounts owed to TEP for energy sales.
61
We calculate counterparty credit exposure by adding any outstanding
receivable (net of amounts payable if a netting agreement exists) to the
mark-to-market value of any forward contracts. As of March 31, 2005, TEP's total
credit exposure related to its wholesale marketing activities (excluding
defaulted amounts owed by the CPX, the CISO and Enron), was approximately $21
million and MEG's total credit exposure related to its trading activities was $6
million. TEP and MEG's credit exposure is diversified across approximately 16
counterparties. Approximately $3 million of exposure is to non-investment grade
companies.
UniSource Energy is also exposed to credit risk related to the sale of
assets owned by Nations Energy Corporation (Nations Energy). In September 2001,
Nations Energy sold its 26% equity interest in a power project located in
Curacao, Netherlands Antilles to Mirant Curacao Investments, Ltd. (Mirant
Curacao) a subsidiary of Mirant Corporation (Mirant). Nations Energy received $5
million in cash and an $11 million note receivable from Mirant Curacao. The note
was recorded at its net present value of $8 million using an 8% discount rate,
the discount being recognized as interest income over the five-year life of the
note. As of March 31, 2005, Nations Energy's receivable from Mirant Curacao is
approximately $8 million. The note is primarily included in Investments and
Other Property-Other on UniSource Energy's balance sheet. The first payment of
$2 million on the receivable was received in July 2004. The remaining payments
on the note receivable are expected to be received as follows: $4 million in
July 2005; and $5 million in July 2006. The note is guaranteed by Mirant
Americas, Inc. a subsidiary of Mirant. On July 14, 2003, Mirant, Mirant
Americas, Inc. and various other Mirant companies filed for Chapter 11
bankruptcy protection. Mirant Curacao was not included in the Chapter 11
filings. Based on a review of the projected cash flows for the power project, it
appears Mirant Curacao will have sufficient future cash flows to pay the note
receivable and any applicable interest. However, we cannot predict the ultimate
outcome that Mirant's bankruptcy will have on the collectibility of the note
from Mirant Curacao. Nations Energy will continue to evaluate the collectibility
of the receivable, but currently expects to collect the note in its entirety and
has not recorded any reserve for this note.
ITEM 4. - CONTROLS AND PROCEDURES
--------------------------------------------------------------------------------
UniSource Energy and TEP have disclosure controls and procedures to ensure
that material information recorded, processed, summarized and reported in their
filings with the SEC is on an accurate and timely basis. Management of UniSource
Energy and TEP, with the participation of the principal executive officer and
principal financial officer of UniSource Energy and TEP, have evaluated these
disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e)
under the Securities Exchange Act of 1934, as amended) as of March 31, 2005.
Based on such evaluation, the principal executive officer and principal
financial officer of UniSource Energy and TEP have concluded that such
disclosure controls and procedures were, as of such date, effective at ensuring
that material information is recorded, processed, summarized and reported
accurately and within the time periods specified by the SEC's rules and forms.
During the fiscal quarter ending March 31, 2005, there have not been any
changes in UniSource Energy or TEP's internal controls over financial reporting
that have materially affected, or are reasonably likely to materially affect,
these controls.
PART II - OTHER INFORMATION
ITEM 1. - LEGAL PROCEEDINGS
--------------------------------------------------------------------------------
See Item 7. - Management's Discussion and Analysis of Financial Condition
and Results of Operations, Tucson Electric Power Company, Factors Affecting
Operations, for litigation related to ACC orders and retail competition.
We discuss other legal proceedings in Note 6 of Notes to Consolidated
Financial Statements.
CROSS-COMPLAINTS IN WHOLESALE ELECTRICITY ANTITRUST CASES I AND II
62
In late 2000, various California municipalities and citizens filed suits
against Duke Energy Trading and Marketing, L.L.C., Reliant Energy Services, Inc.
and other large suppliers of wholesale electricity alleging that Duke, Reliant,
and the other large suppliers violated antitrust laws by colluding to effect the
price of electricity in the California wholesale electricity market. These
actions were subsequently consolidated in San Diego Superior Court in March 2002
as Wholesale Electricity Antitrust Cases I and II.
Duke and Reliant responded by filing cross-complaints against TEP and
numerous other wholesale electricity market participants in April 2002. The
cross complaints allege that cross-defendants sold power in significant amounts
at prices the antitrust plaintiffs allege were excessive, and as participants in
power sales, cross-defendants are equally liable for plaintiffs alleged damages.
The entire action was removed to the United States District Court for the
Southern District of California in May 2002. The antitrust plaintiffs responded
to the removal by filing a motion for remand, and on December 13, 2002, the
District Court remanded the case back to state court.
Duke and Reliant appealed the District Court's remand order and requested
that the order be stayed pending resolution of their appeal. On December 8,
2004, the Ninth Circuit affirmed the District Court's remand and similarly
denied a subsequent petition for rehearing and motion to recall the mandate. The
mandate has now been issued and the case is in the process of being removed to
state court. Upon remand, TEP expects to file a motion to dismiss the
cross-complaint.
TEP believes these claims are without merit and intends to vigorously
contest them.
CITY OF TACOMA
On June 7, 2004, the City of Tacoma, Washington filed a lawsuit (City of
Tacoma v. American Electric Power Services Corporation, et al. (U.S. District
Ct. W. D. Wash.)) against TEP and various other electricity generators and
marketers alleging that the defendants violated antitrust laws by colluding to
effect the price of electricity in the Pacific Northwest from May 2000 through
2001. These claims are similar to those alleged in the antitrust cases against
TEP and other wholesale electricity market participants described above in
Cross-Complaints in Wholesale Electricity Antitrust Cases I and II. On September
14, 2004, the case was transferred to the United States District Court for the
Southern District of California. TEP along with other defendants filed a joint
motion to dismiss and the motion was granted on February 11, 2005. The City of
Tacoma appealed the dismissal to the Ninth Circuit and the appeal is now
pending.
TEP believes these claims are without merit and intends to vigorously
contest them.
ITEM 5. - OTHER INFORMATION
--------------------------------------------------------------------------------
TEP CREDIT AGREEMENT
See Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations, Tucson Electric Power Company, Liquidity and Capital
Resources, for a description of the TEP Credit Agreement entered into on May 4,
2005.
NON-GAAP MEASURES
ADJUSTED EBITDA
---------------
Adjusted EBITDA represents EBITDA excluding the cumulative effect of
accounting change which is a non-cash item. EBITDA is earnings before interest,
taxes, depreciation and amortization. Adjusted EBITDA is presented here as a
measure of liquidity because it can be used as an indication of a company's
ability to incur and service debt and is commonly used as an analytical
indicator in our industry. Adjusted EBITDA measures presented may not be
comparable to similarly titled measures used by other companies. Adjusted EBITDA
is not a measurement presented in accordance with United States generally
accepted accounting principles (GAAP), and we do not intend Adjusted EBITDA to
represent cash flows from operations as defined by GAAP. Adjusted EBITDA should
not be considered to be an alternative to cash flows from operations or any
other items calculated in accordance with GAAP or an indicator of our operating
performance.
63
UniSource Energy and TEP view Adjusted EBITDA, a non-GAAP financial
measure, as a liquidity measure. The most directly comparable GAAP measure to
Adjusted EBITDA is Net Cash Flows from Operating Activities.
ADJUSTED EBITDA AND NET CASH FLOWS FROM OPERATING ACTIVITIES
THREE MONTHS ENDED MARCH 31,
UNISOURCE ENERGY 2005 2004
------------------------------------------------- -----------------------------
- Millions of Dollars -
Adjusted EBITDA $ 80 $ 101
Net Cash Flows from Operating Activities $ 40 $ 44
------------------------------------------------- -------------- --------------
THREE MONTHS ENDED MARCH 31,
TEP 2005 2004
------------------------------------------------- -----------------------------
- Millions of Dollars -
Adjusted EBITDA $ 71 $ 84
Net Cash Flows from Operating Activities $ 37 $ 36
------------------------------------------------- -------------- --------------
RECONCILIATION OF ADJUSTED EBITDA TO CASH FLOWS FROM OPERATIONS
THREE MONTHS ENDED MARCH 31,
UNISOURCE ENERGY 2005 2004
------------------------------------------------------------------- -------------- --------------
- Millions of Dollars -
ADJUSTED EBITDA (1) $ 80 $ 101
Amounts from the Income Statements:
Less: Income Taxes (2) 6
Less: Total Interest Expense 40 43
Changes in Assets and Liabilities and Other Non-Cash Items (2) (8)
------------------------------------------------------------------- -------------- --------------
NET CASH FLOWS FROM OPERATING ACTIVITIES $ 40 $ 44
=================================================================== ============== ==============
64
THREE MONTHS ENDED MARCH 31,
TEP 2005 2004
------------------------------------------------------------- -----------------------------
- Millions of Dollars -
ADJUSTED EBITDA (1) $ 71 $ 84
Amounts from the Income Statements:
Less: Income Taxes (2) 2
Less: Total Interest Expense 37 40
Changes in Assets and Liabilities and Other Non-Cash Items 1 (6)
------------------------------------------------------------- -------------- --------------
NET CASH FLOWS FROM OPERATING ACTIVITIES $ 37 $ 36
============================================================= ============== ==============
(1) ADJUSTED EBITDA WAS CALCULATED AS FOLLOWS:
THREE MONTHS ENDED MARCH 31,
UNISOURCE ENERGY 2005 2004
------------------------------------------------------------- -----------------------------
- Millions of Dollars -
NET INCOME $ (4) $ 6
Amounts from the Income Statements:
Plus: Income Taxes (2) 6
Plus: Total Interest Expense 40 43
Plus: Depreciation and Amortization 35 35
Plus: Amortization of Transition Recovery Asset 9 9
Plus: Depreciation included in Fuel and Other O&M
Expense (see Note 13 of Notes to Consolidated
Financial Statements) 2 2
------------------------------------------------------------- -------------- --------------
ADJUSTED EBITDA $ 80 $ 101
============================================================= ============== ==============
THREE MONTHS ENDED MARCH 31,
TEP 2005 2004
------------------------------------------------------------- -----------------------------
- Millions of Dollars -
NET INCOME $ (5) $ 1
Amounts from the Income Statements:
Plus: Income Taxes (2) 2
Plus: Total Interest Expense 37 40
Plus: Depreciation and Amortization 30 30
Plus: Amortization of Transition Recovery Asset 9 9
Plus: Depreciation included in Fuel and Other O&M
Expense (see Note 13 of Notes to Consolidated
Financial Statements) 2 2
------------------------------------------------------------- -------------- --------------
ADJUSTED EBITDA $ 71 $ 84
============================================================= ============== ==============
NET DEBT AND TOTAL DEBT AND CAPITAL LEASE OBLIGATIONS - TEP
-----------------------------------------------------------
Net Debt represents the current and non-current portions of TEP's long-term
debt and capital lease obligations less investment in lease debt. We have
subtracted investment in lease debt because it represents TEP's ownership of the
debt component of its own capital lease obligations. Net Debt measures presented
may not be comparable to similarly titled measures used by other companies. Net
Debt is not a measurement presented in accordance with GAAP and we do not intend
Net Debt to represent debt as defined by GAAP. You should not consider Net Debt
to be an alternative to debt or any other items calculated in accordance with
GAAP.
65
AS OF MARCH AS OF DECEMBER
31, 2005 31, 2004
------------------------------------------------------------------------- -------------- -------------------
- Millions of Dollars -
Net Debt $ 1,595 $ 1,684
Total Debt and Capital Lease Obligations $ 1,757 $ 1,855
------------------------------------------------------------------------- -------------- -------------------
RECONCILIATION OF TOTAL DEBT AND CAPITAL LEASE OBLIGATIONS TO NET DEBT
AS OF MARCH AS OF DECEMBER
31, 2005 31, 2004
------------------------------------------------------------------------- -------------- -------------------
- Millions of Dollars -
Long-Term Debt $ 1,046 $ 1,098
Current Portion - Long-Term Debt - 2
------------------------------------------------------------------------- -------------- -------------------
TOTAL DEBT 1,046 1,100
------------------------------------------------------------------------- -------------- -------------------
Capital Lease Obligations 655 701
Current Portion - Capital Lease Obligations 56 54
------------------------------------------------------------------------- -------------- -------------------
TOTAL DEBT AND CAPITAL LEASE OBLIGATIONS 1,757 1,855
------------------------------------------------------------------------- -------------- -------------------
Investment in Lease Debt (162) (171)
------------------------------------------------------------------------- -------------- -------------------
NET DEBT $ 1,595 $ 1,684
========================================================================= ============== ===================
RATIO OF EARNINGS TO FIXED CHARGES
----------------------------------
The following table reflects the ratio of earnings to fixed charges for
UniSource Energy and TEP:
3 Months Ended 12 Months Ended
March 31, 2005 March 31, 2005
------------------------- ---------------------- -------------------------
UniSource Energy 0.88* 1.37
TEP 0.82** 1.46
* UniSource Energy's Ratio of Earnings to Fixed Charges for the 3 months ended
March 31, 2005 is less than one-to-one coverage due to: the seasonal nature of
TEP's business; losses incurred by Global Solar; and losses from other
non-reportable segments. In the first quarter of 2005, TEP incurred a net loss
of $5 million, Global Solar incurred a net loss of $2 million and other
non-reportable segments incurred a net loss of $2 million. The amount of the
deficiency needed to attain a one-to-one coverage would be $4 million.
**TEP's Ratio of Earnings to Fixed Charges for the 3 months ended March 31, 2005
is less than one-to-one coverage as a result of the seasonal nature of TEP's
business. In the first quarter of 2005, TEP incurred a net loss of $5 million.
The amount of the deficiency needed to attain a one-to-one coverage would be $7
million.
SEC REPORTS AVAILABLE ON UNISOURCE ENERGY'S WEBSITE
---------------------------------------------------
UniSource Energy and TEP make available their annual reports on Form 10-K,
quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments
to those reports as soon as reasonably practicable after they electronically
file them with, or furnish them to, the SEC. These reports are available free of
charge through UniSource Energy's website address:
http://www.unisourceenergy.com. A link from UniSource Energy's website to these
SEC reports is accessible as follows: At the UniSource Energy main page, select
Investor Relations from the menu shown at the top of the page; next select SEC
filings from the menu shown on the Investor Relations page.
Information contained at UniSource Energy's website is not part of any
report filed with the SEC by UniSource Energy or TEP.
66
The SEC also maintains an Internet site that contains reports, proxy and
information statements, and other information regarding issuers that file
electronically with the SEC. The SEC website address is http://www.sec.gov.
Interested parties may also read and copy any materials UniSource Energy or TEP
file with the SEC at the SEC's Public Reference Room at 450 Fifth Street, NW,
Washington, DC 20549. Information on the operation of the Public Reference Room
is available by calling the SEC at 1-800-SEC-0030.
ITEM 6. - EXHIBITS
--------------------------------------------------------------------------------
See Exhibit Index.
67
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, each
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized. The signature for each undersigned
company shall be deemed to relate only to matters having reference to such
company or its subsidiaries.
UNISOURCE ENERGY CORPORATION
----------------------------
(Registrant)
Date: May 9, 2005 /s/ Kevin P. Larson
----------------------------------------
Kevin P. Larson
Vice President and Principal
Financial Officer
TUCSON ELECTRIC POWER COMPANY
(Registrant)
Date: May 9, 2005 /s/ Kevin P. Larson
----------------------------------------
Kevin P. Larson
Vice President and Principal
Financial Officer
68
EXHIBIT INDEX
-------------
4(a) -- TEP Credit Agreement, dated as of May 4, 2005, among TEP, the
Lenders Party Thereto, the Issuing Banks Party Thereto,
Union Bank of California, N.A., as Lead Arranger and
Administrative Agent, Wells Fargo Bank, National
Association, as Syndication Agent, and Allied Irish Banks,
P.L.C., as Documentation Agent.
4(b) -- Supplemental Indenture No.6, dated as of May 1, 2005, creating
a series of bonds designated Second Mortgage Bonds,
Collateral Series E.
12(a) -- Computation of Ratio of Earnings to Fixed Charges -
UniSource Energy.
12(b) -- Computation of Ratio of Earnings to Fixed Charges - TEP.
15 -- Letter regarding unaudited interim financial information.
31(a) -- Certification Pursuant to Section 302 of the Sarbanes-Oxley Act -
UniSource Energy, by James S. Pignatelli.
31(b) -- Certification Pursuant to Section 302 of the Sarbanes-Oxley Act -
UniSource Energy, by Kevin P. Larson.
31(c) -- Certification Pursuant to Section 302 of the Sarbanes-Oxley Act -
TEP, by James S. Pignatelli.
31(d) -- Certification Pursuant to Section 302 of the Sarbanes-Oxley Act -
TEP, by Kevin P. Larson.
*32 -- Statements of Corporate Officers (pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002).
*Pursuant to Item 601(b)(32)(ii) of Regulation S-K, this certificate is not
being filed for purposes of Section 18 of the Securities Exchange Act of 1934.
69
APPENDIX C
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON D.C. 20549
SCHEDULE 14A
Proxy Statement Pursuant to Section 14(a) of the
Securities Exchange Act of 1934
(Amendment No. )
Filed by the Registrant [X]
Filed by a Party other than the Registrant [ ]
Check the appropriate box:
[ ] Preliminary Proxy Statement
[ ] Confidential, for Use of the Commission Only (as permitted by Rule
14a-6(e)(2))
[X] Definitive Proxy Statement
[ ] Definitive Additional Materials
[ ] Soliciting Material Pursuant to Sections 240.14a-11(c) or 240.14a-12
UNISOURCE ENERGY CORPORATION
--------------------------------------------------------------------------------
(Name of the Registrant as Specified In Its Charter)
--------------------------------------------------------------------------------
(Name of Person(s) Filing Proxy Statement, if other than the Registrant)
Payment of Filing Fee (Check the appropriate box):
[X] No fee required.
[ ] Fee computed on table below per Exchange Act Rules 14a-6(i)(1) and 0-11.
1) Title of each class of securities to which transaction applies:
2) Aggregate number of securities to which transaction applies:
3) Per unit price or other underlying value of transaction computed
pursuant to Exchange Act Rule 0-11(set forth the amount on which the
filing fee is calculated and state how it was determined):
4) Proposed maximum aggregate value of transaction:
5) Total fee paid:
[ ] Fee paid previously with preliminary materials.
[ ] Check box if any part of the fee is offset as provided by Exchange Act Rule
0-11(a)(2) and identify the filing for which the offsetting fee was paid
previously. Identify the previous filing by registration statement number,
or the Form or Schedule and the date of its filing.
1) Amount Previously Paid:
2) Form, Schedule or Registration Statement No.:
3) Filing Party:
4) Date Filed:
UNISOURCE ENERGY CORPORATION
One South Church Avenue
Tucson, Arizona 85701
April 6, 2005
James S. Pignatelli (520) 571-4000
Chairman of the Board
Dear Shareholders:
You are cordially invited to attend the UniSource Energy Corporation
2005 Annual Shareholders' Meeting to be held on Friday, May 6, 2005, at the
Marriott University Park Hotel, 880 East Second Street, Tucson, Arizona. The
meeting will begin promptly at 10:00 a.m., Mountain Standard Time, so please
plan to arrive earlier. No admission tickets will be required for attendance at
the meeting.
Directors and officers will be available before and after the meeting
to speak with you. During the meeting, we will answer your questions regarding
our business affairs and we will consider the matters explained in the enclosed
Proxy Statement.
We have enclosed a proxy card that lists all matters that require your
vote. Please complete, sign, date and mail the proxy card as soon as possible,
whether or not you plan to attend the meeting. You may also vote by telephone or
the Internet, as explained on the enclosed proxy card. If you attend the meeting
and wish to vote your shares personally, you may revoke your proxy at that time.
Your interest in and continued support of UniSource Energy Corporation
are much appreciated.
Sincerely,
UNISOURCE ENERGY CORPORATION
/s/ James S. Pignatelli
-----------------------
James S. Pignatelli
Chairman of the Board, President and
Chief Executive Officer
NOTICE OF ANNUAL SHAREHOLDERS' MEETING
To the Holders of Common Stock of
UniSource Energy Corporation
We will hold the 2005 Annual Shareholders' Meeting ("Meeting") of
UniSource Energy Corporation at the Marriott University Park Hotel, 880 East
Second Street, Tucson, Arizona, on May 6, 2005, at 10:00 a.m., Mountain Standard
Time ("MST"). The purpose of the Meeting is to:
1. elect nine directors to our Board of Directors for the ensuing year; and
2. consider any other matters which properly come before the Meeting.
Only shareholders of record at the close of business on March 28, 2005,
are entitled to vote at the Meeting.
We have enclosed our 2004 Annual Report, including audited financial
statements, and the Proxy Statement with this notice. Proxy soliciting material
is first being sent or given to shareholders on or about April 6, 2005. Your
proxy is being solicited by our Board of Directors.
Please complete, sign, date and mail the enclosed proxy card as soon as
possible, or vote by telephone or the Internet, as explained on the enclosed
proxy card.
/s/ Catherine A. Nichols
------------------------
Catherine A. Nichols
Corporate Secretary
Dated: April 6, 2005
YOUR VOTE IS IMPORTANT
EACH SHAREHOLDER IS URGED TO COMPLETE, SIGN, DATE AND RETURN PROMPTLY THE
ENCLOSED PROXY CARD BY zMAIL, OR TO VOTE BY TELEPHONE OR THE INTERNET, AS
EXPLAINED ON THE ENCLOSED PROXY CARD. IF THE MAIL OPTION IS SELECTED, USE THE
ENCLOSED ENVELOPE, WHICH DOES NOT REQUIRE POSTAGE IF MAILED IN THE UNITED
STATES. RETURNING A SIGNED PROXY WILL NOT PROHIBIT YOU FROM ATTENDING THE
MEETING AND VOTING IN PERSON IF YOU SO DESIRE.
UNISOURCE ENERGY CORPORATION
One South Church Avenue
Tucson, Arizona 85701
ANNUAL SHAREHOLDERS' MEETING
PROXY STATEMENT
Annual Meeting May 6, 2005 Marriott University Park Hotel
10:00 a.m., MST 880 East Second Street
Tucson, Arizona 85719
Record Date The record date is March 28, 2005 ("Record Date"). If you
were a shareholder of record at the close of business on
the Record Date, you may vote at the 2005 Annual
Shareholders' Meeting ("Meeting") of UniSource Energy
Corporation ("UniSource Energy" as well as references to
"we," "our" and "us"). At the close of business on the
Record Date, we had 34,547,161 shares of common stock
outstanding.
Agenda 1. Proposal One: Elect nine directors to our Board
of Directors ("Board") for the ensuing year.
2. Consider any other matters which properly come
before the Meeting and any adjournments.
Independent Representatives of PricewaterhouseCoopers, LLP are expected
Auditors to be present at the Meeting with the opportunity to make a
statement and respond to appropriate questions from our
shareholders.
Proxies A form of proxy for execution by shareholders is enclosed.
Unless you tell us on the proxy card to vote differently, we
We will we will vote signed returned proxies "for" differently,
follow your the Board's nominees. The Board or proxy holders will use
voting their discretion on other matters that properly come before
instructions. the Meeting. If a nominee cannot or will not serve as a
If none, we director, the Board or the persons designated as proxies
will vote will vote for a person who they believe will carry on our
signed our present policies.
proxies
"for" the
nominees.
Proxies
Solicited by The Board.
First Mailing We anticipate first mailing this Proxy Statement along with
Date the proxy card on or about April 6, 2005.
Revoking Your You may revoke your proxy before it is voted at the Meeting.
Proxy To revoke, follow the procedures listed on page 3 under
"Voting Procedures/Revoking Your Proxy."
Comments Your comments about any aspects of our business are
welcome. You may use the space provided on the proxy card
We welcome your for this urpose, if desired. Although we may not respond
comments. The on an individual basis, your comments help us to measure
proxy card has your satisfaction, and we may benefit from your suggestions.
room for them.
PLEASE VOTE - YOUR VOTE IS IMPORTANT
Prompt return of your proxy will help reduce the costs of re-solicitation.
1
CONTENTS
Voting Procedures/Revoking Your Proxy........................................ 2
UniSource Energy Share Ownership............................................. 3
Proposal One: Election of Directors*......................................... 6
Board Information............................................................ 8
Board Compensation........................................................... 11
Executive Compensation and Other Information**............................... 13
Equity Compensation Plan Information......................................... 15
Officer Change in Control Agreements......................................... 18
Director Independence Criteria............................................... 19
Transactions with Management and Others...................................... 20
Compensation Committee Report on Executive Compensation...................... 21
Audit Committee Report....................................................... 24
Performance Graph**.......................................................... 27
Submission of Shareholder Proposals.......................................... 28
Other Business............................................................... 28
Appendix A.................................................................. A-1
-------------------
* We expect to vote on this item at the Meeting.
** The Compensation Committee Report and the Performance Graph will not be
incorporated by reference into any present or future filings we make with
the Securities and Exchange Commission ("SEC"), even if those reports
incorporate all or any part of this Proxy Statement.
VOTING PROCEDURES/REVOKING YOUR PROXY
You can vote by You can vote your shares by telephone, the Internet, mail
telephone, the or in person at the Meeting. Your proxy card contains
Internet, mail or instructions for voting by telephone or the Internet,
in person. We which are the least expensive and fastest methods of
encourage you to voting. To vote by mail, complete, sign and date your
vote by telephone proxy card, or your broker's voting instruction card if
or the Internet to your shares are held by your broker, and return it in the
help us save money. enclosed return envelope.
Under Arizona law, a majority of the shares entitled to
vote on any single matter which may be brought before the
Meeting will constitute a quorum. Business may be
conducted once a quorum is represented at the Meeting.
Except as otherwise specified by law or in our Articles of
Incorporation or Bylaws, if a quorum exists, action on a
matter other than the election of directors will be deemed
approved if the votes cast in favor of the matter exceed
votes cast against it.
Directors are elected by a plurality of the votes cast by
the shares entitled to vote if a quorum is present. A
plurality means receiving the largest number of votes,
regardless of whether that is a majority. Withheld votes
will be counted as being represented at the Meeting for
quorum purposes but will not have an effect on the vote.
2
You may cumulate In the election of directors, each shareholder has the
your votes for right to cumulate his votes by casting a total number of
directors. votes equal to the number of his shares of common stock
multiplied by the number of directors to be elected. He
may cast all of such votes for one nominee or distribute
such votes among two or more nominees. For any other
matter that may properly come before the Meeting, each
share of common stock will be entitled to one vote.
You can revoke your Any shareholder giving a proxy has a right to revoke that
proxy after sending proxy by giving notice to UniSource Energy in writing
it in by following directed to the Corporate Secretary, UniSource Energy
these procedures. Corporation, One South Church Avenue, Suite 200, Tucson,
Arizona 85701, or in person at the Meeting at any time
before the proxy is exercised. Those who fail to return a
proxy or fail to attend the Meeting will not count
towards determining any required plurality, majority or
quorum.
The shares represented by an executed proxy will be voted
for the election of directors or withheld in accordance
with the specifications in the proxy. If no specification
is made in an executed proxy, the proxy will be voted in
favor of the nominees as set forth herein.
Proxy Solicitation We will bear the entire cost of the solicitation of
proxies. Solicitations will be made primarily by mail.
Additional solicitation of brokers, banks, nominees and
institutional investors may be made pursuant to a special
engagement of DF King & Co., Inc., at a cost of
approximately $7,500 plus reasonable out-of-pocket
expenses. Solicitations may also be made by telephone,
facsimile or personal interview, if necessary, to obtain
reasonable representation of shareholders at the Meeting.
Our employees may solicit proxies for no additional
compensation. We will request brokers or other persons
holding stock in their names, or in the names of their
nominees, to forward proxy materials to the beneficial
owners of such stock or request authority for the
execution of the proxies. We will reimburse brokers and
other persons for reasonable expenses they incur in
sending these proxy materials to you if you are a
beneficial holder of our shares.
UNISOURCE ENERGY SHARE OWNERSHIP
Security Ownership The following table sets forth the number and percentage
of Management of shares beneficially owned as of the Record Date and
the nature of such ownership by each of our directors
(all of which are nominees), our Chief Executive Officer
and our five other most highly compensated executive
officers at January 5, 2005 (the "Named Executives") and
all directors and officers as a group. Ownership includes
direct and indirect (beneficial) ownership, as defined by
the SEC rules.
Name and Amount and
Title Title of Nature of Beneficial Percent
of Class Beneficial Owner Ownership (1) of Class
-------- ---------------- -------------------- --------
Common James S. Pignatelli 737,547 (2) 2.2%
Chairman, President and
Chief Executive Officer
Common Lawrence J. Aldrich 11,484 (3) *
Director
3
Name and Amount and
Title Title of Nature of Beneficial Percent
of Class Beneficial Owner Ownership (1) of Class
-------- ---------------- -------------------- --------
Common Larry W. Bickle 17,424 (4) *
Director
Common Elizabeth T. Bilby 15,077 (5) *
Director
Common Harold W. Burlingame 13,677 (4) *
Director
Common John L. Carter 24,231 (6) *
Director
Common Robert A. Elliott 1,610 (7)
Director
Common Kenneth Handy 8,477 (8) *
Director
Common Warren Y. Jobe 6,885 (8) *
Director
Common Steven J. Glaser 211,371 (9) *
Senior Vice President and
Chief Operating Officer, Transmission
& Distribution - Tucson Electric
Power Company ("TEP")
Common Dennis R. Nelson 195,490 (10) *
Senior Vice President and Chief Operating
Officer - UniSource Energy Services, Inc.
("UES")
Common Michael J. DeConcini 144,888 (11) *
Senior Vice President, Investments
and Planning / Senior Vice President
and Chief Operating Officer,
Energy Resources - TEP
Common Kevin P. Larson 126,255 (12) *
Vice President, Chief Financial Officer and
Treasurer
Common Vincent Nitido, Jr. 159,565 (13) *
Vice President, General Counsel and Chief
Administrative Officer
Common All directors and executive officers as a 2,016,052 (14) 5.8%
group
-------------------
* Represents less than 1% of the outstanding common stock of UniSource Energy.
(1) Amounts include the following:
o Any shares held in the name of the spouse, minor children or other
relatives sharing the home of the director or officer. Except as
otherwise indicated below, the directors and officers have sole voting
and investment power over the shares shown. Voting power includes the
power to direct the voting of the shares held, and investment power
includes the power to direct the disposition of the shares held.
o Shares subject to options exercisable within 60 days, based on
information from E*Trade, UniSource Energy's stock option plan
administrator.
4
o Equivalent share amounts allocated to the individuals' 401(k) Plan
which, since June 1, 1998, has included a UniSource Energy Stock Fund
investment option.
(2) Includes 707,764 shares subject to options exercisable within 60 days, and
15,708 shares purchased under the 401(k) Plan UniSource Energy Stock Fund
as of December 31, 2004.
(3) Includes 7,572 shares subject to options exercisable within 60 days.
(4) Includes 10,772 shares subject to options exercisable within 60 days.
(5) Includes 14,372 shares subject to options exercisable within 60 days.
(6) Includes 13,172 shares subject to options exercisable within 60 days.
(7) Includes 797 shares subject to options exercisable within 60 days.
(8) Includes 5,572 shares subject to options exercisable within 60 days.
(9) Includes 186,201 shares subject to options exercisable within 60 days,and
2,693 shares purchased under the 401(k) Plan UniSource Energy Stock Fund
as of December 31, 2004.
(10) Includes 178,988 shares subject to options exercisable within 60 days, and
8,420 shares purchased under the 401(k) Plan UniSource Energy Stock Fund
as of December 31, 2004.
(11) Includes 135,008 shares subject to options exercisable within 60 days, and
4,910 shares purchased under the 401(k) Plan UniSource Energy Stock Fund
as of December 31, 2004.
(12) Includes 105,154 shares subject to options exercisable within 60 days, and
2,337 shares purchased under the 401(k) Plan UniSource Energy Stock Fund
as of December 31, 2004.
(13) Includes 139,654 shares subject to options exercisable within 60 days, and
4,017 shares purchased under the 401(k) Plan UniSource Energy Stock Fund
as of December 31, 2004.
(14) Includes 1,818,311 shares subject to options exercisable within 60 days,
and 39,386 shares purchased under the 401(k) Plan UniSource Energy Stock
Fund as of December 31, 2004.
Security As of March 28, 2005, based on information reported in
Ownership of filings made by the following persons with the SEC or
Certain information otherwise known to us, the following
Beneficial Owners persons were known or reasonably believed to be, as
more fully described below, the beneficial owners of
more than 5% of our common stock:
Amount and
Name and Address Nature of Percent
Title of Class of Beneficial Owner Beneficial Ownership of Class
-------------- ------------------- -------------------- --------
Common Third Point Management Co., LLC 2,900,000 (1) 8.5%
360 Madison Ave., 24th Floor
New York, NY 10017
Common Zimmer Lucas Capital, LLC 2,429,000 (2) 7.1%
45 Broadway, 28th Floor
New York, NY 10006
Common White Mountains Insurance Group 2,293,100 (3) 6.7%
80 South Main Street
Hanover, NH 03755
Common Shumway Capital Partners, LLC 2,205,600 (4) 6.4%
600 Steamboat Road
Greenwich, CT 06830
-------------------
(1) In a statement (Schedule 13D) filed with the SEC on February 7, 2005, Third
Point Management Co., LLC ("Third Point") indicated it has shared voting
and shared dispositive power over 2,900,000 shares of our common stock.
Third Point indicated that 1,714,700 shares are beneficially owned by the
Third Point Offshore Fund, Ltd.
(2) In a statement (Schedule 13G) filed with the SEC on January 3, 2005, Zimmer
Lucas Capital, LLC indicated that it has shared voting and shared
dispositive power over 2,429,000 shares of our common stock.
(3) In a statement (Schedule 13G) filed with the SEC on February 11, 2005,
White Mountains Insurance Group ("WMIG") indicated that it has shared
voting and shared dispositive power over 2,293,100 shares of our common
stock. WMIG indicated that it indirectly controls, through various
wholly-owned subsidiaries and certain of its employee benefit plans,
2,293,100 shares. WMIG stated that the shares are beneficially owned by (i)
wholly-owned subsidiaries of WMIG which are controlled by either White
Mountains Advisors LLC (1,215,000 shares) or a third party pursuant to an
investment
5
advisory agreement (28,100 shares), (ii) employee benefit plans of
WMIG which are controlled by White Mountains Advisors LLC (830,000
shares) and (iii) third parties which are controlled by White Mountains
Advisors LLC pursuant to an investment advisory agreement (220,000 shares).
(4) In a statement (Schedule 13G) filed with the SEC on February 4, 2005,
Shumway Capital Partners, LLC indicated that it has shared voting and
shared dispositive power over 2,205,600 shares of our common stock.
Section 16(a) Section 16(a) of the Securities Exchange Act of 1934,
Beneficial as amended, and regulations of the SEC require our
Ownership executive officers, directors and persons who
Reporting beneficially own more than 10% of our common stock,
Compliance as well as certain affiliates of those persons, to
file initial reports of ownership and monthly
transaction reports covering any changes in ownership
with the SEC and the New York Stock Exchange
("NYSE"). SEC regulations require these persons to
furnish us with copies of all reports they file
pursuant to Section 16(a).
Based solely upon a review of the copies of the
reports received by us and on written representations
of our directors and officers, we believe that,
during fiscal year 2004, except as described below,
all filing requirements applicable to executive
officers and directors were complied with in a timely
manner. Forms 4 reporting our January 2, 2004
restricted stock grants and restricted stock unit
grants to our non-employee directors (Mr. Aldrich,
Mr. Bickle, Ms. Bilby, Mr. Burlingame, Mr. Carter,
Mr. Elliott, Mr. Handy, and Mr. Jobe) were filed
late. Forms 4 reporting stock option exercises by Mr.
Delawder on February 12, 2004, Ms. Nichols on March
24, 2004, Ms. Kissinger on May 28, 2004, Mr. Hansen
on June 4, 2004, and Mr. DeConcini on June 7, 2004
and, in the case of Mr. Delawder, Ms. Nichols, and
Mr. DeConcini, related sales of stock on the option
exercise dates, were filed late. Forms 4 reporting
dividend equivalent stock units credited under our
Omnibus Stock and Incentive Plan, our Outside
Director Stock Optio n Plan, and our Management and
Director Deferred Compensation Plan, as applicable,
on June 10, 2004 and again on October 4, 2004 for
each of our non-employee directors identified above
and for each of Mr. DeConcini, Mr. Delawder, Mr.
Glaser, Mr. Hansen, Ms. Kissinger, Mr. Larson, Mr.
Nelson, Mr. Nitido and Mr. Pignatelli were filed
late.
PROPOSAL ONE: ELECTION OF DIRECTORS
General At the Meeting, our shareholders of record will
elect nine directors to serve on our Board for the
We will elect ensuing year and until their successors are elected
nine directors and qualified. The shares represented by executed
this year. proxies in the form enclosed, unless withheld, will
be voted for the nine nominees listed below, or, in
the discretion of the persons acting as proxies,
will be voted cumulatively for one or more of such
nominees. All of the current nominees are present
members of the Board. All of the nominees have
consented to serve if elected. If any nominee
becomes unavailable for any reason, or a vacancy
should occur before the election, it is the
intention of the persons designated as proxies to
vote, in their discretion, for other nominees.
6
BOARD NOMINEES
James S. Chairman of the Board, President and Chief
Pignatelli Executive Officer of UniSource Energy since July
1998; Senior Vice President and Chief Operating
Officer of UniSource Energy from December 1997 to
July 1998; Chairman of the Board of Directors,
President and Chief Executive Officer of TEP, the
principal subsidiary of UniSource Energy, since
July 1998; Executive Vice President and Chief
Operating Officer of TEP from March 1998 to July
1998; Senior Vice President and Chief Operating
Officer of TEP from 1996 to 1998; Chairman of the
Board of Directors, President and Chief Executive
Officer of Millennium Energy Holdings, Inc.
("Millennium"), a wholly owned subsidiary of
UniSource Energy, since 1997; Director of UES, a
wholly-owned subsidiary of UniSource Energy, since
2003. Board member since 1998. Age 61.
Lawrence J. General Partner, Valley Ventures, LP, since
Aldrich September 2002; Managing Director and Founder,
(4) Tucson Ventures, LLC, from February 2000 to
September 2002; President and Chief Executive
Officer of Tucson Newspapers from January 1992 to
February 2000; Director of TEP and Millennium since
2000; Director of UES since 2004. Board member
since 2000. Age 52.
Larry W. Bickle Managing Director of Haddington Ventures, LLC, an
(4) investment company, since 1997; Director of St.
Mary Land and Exploration since 1995; Director of
Millennium since 1998; Director of UES since 2004;
Responsible Director of Infinite Power Solutions,
Inc. ("IPS") since 2004. Board member since 1998.
Age 59.
Elizabeth T. Retired President of Gourmet Products, Inc., an
Bilby agricultural product marketing company; Retired
(4) Director of Marketing of Green Valley Pecans.
Director of TEP since 1995; Director of Millennium
from 1998-2003; Director of UES since 2004. Board
member since 1995. Age 65.
Harold W. Senior Executive Advisor for Cingular Wireless
Burlingame Services (formerly AT&T Wireless) since July 2001;
(1)(2)(3) Executive Vice President, Communications and Human
Resources of AT&T Wireless Services from April 2000
to June 2001; Executive Vice President, Merger and
Joint Venture Integration of AT&T from March 1999
to March 2000; Executive Vice President of Human
Resources of AT&T from 1987 to March 1999; Member
of the AT&T Foundation from November 1986 to
December 2002; Chair, Executive Committee,
Organization Resources Counselors since June 1999;
Director of TEP since 1998. Board member since
1998. Age 64.
John L. Carter Retired from IBM in 1987; held executive positions
(1)(2)(3)(4) at various locations in IBM, including General
Manager of IBM, Tucson, Arizona. President and
Chief Executive Officer of Qualtronics
Manufacturing, Inc. from 1987 to 1993. Retired as
Executive Vice President and Chief Financial
Officer of Burr-Brown Corporation in 1996. Director
of TEP since 1996; Director of Millennium since
1998; Director of UES since 2004; Responsible
Director of Global Solar Energy, Inc. ("GSE") since
2004. Board member since 1996. Age 70.
7
Robert A. Elliott President and owner of The Elliott Accounting Group
(1)(2)(3) since 1983; Director and Minority Shareholder of
Southern Arizona Community Bank since 1998;
Director of Tucson Urban League from 1998 to 2004;
Television Analyst/Pre-game Show Co-host for Fox
Sports Arizona since 1999; Corporate Secretary of
Southern Arizona Community Bank since 1999; Radio
Host of "In the Paint" Sports Talk Show from 2000
to 2004; Chairman of the Board of Tucson
Metropolitan Chamber of Commerce since 2002;
Treasurer of Tucson Urban League from 2002 to 2003;
Chairman of the Board of Tucson Urban League from
2003 to 2004; Director of TEP since May 2003. Board
member since 2003. Age 49.
Kenneth Handy Retired CPA; Vice President and Chief Financial
(1)(2)(3) Officer of The Permanente Medical Group, Inc. (the
physician services component of the Kaiser
Permanente Medical Care Program in Northern
California) from 1978 to 1998; Partner at Ernst &
Ernst (now Ernst & Young) from 1972 to 1978;
Director of TEP since 2001; Director of Millennium
from 2001 to 2003; Lead Director of UES since 2004.
Board member since 2001. Age 66.
Warren Y. Jobe Retired CPA; Senior Vice President of Southern
(2)(3)(4) Company from 1998 to 2001; Executive Vice President
and Chief Financial Officer and member of the Board
of Directors of Georgia Power Company from 1982 to
1998; former President of the Georgia Power
Foundation Inc. from 1986 to 2001; Director of
Wellpoint, Inc. since 2001; Director of TEP since
2001; Director of Millennium from 2001 to 2003;
Director of HomeBanc Corporation since 2004;
Director of STI Classic Funds since 2004. Board
member since 2001. Age 64.
(1) Member of the Corporate Governance and Nominating Committee.
(2) Member of the Audit Committee.
(3) Member of the Compensation Committee.
(4) Member of the Finance Committee.
The Board recommends that you vote "FOR" these nominees.
BOARD INFORMATION
Board Meetings In 2004, the Board held a total of 13 regular and
special meetings. Each director attended at least 75% of
his or her Board and committee meetings. Additionally,
the non-management directors met at regularly scheduled
executive sessions without management present. Mr.
Carter was the Lead Director at these executive sessions.
Board Shareholders or other interested parties wishing to
Communication communicate with the Board, the non-management directors
or any individual director may contact the Lead Director
by mail, addressed to UniSource Energy Lead Director,
c/o Corporate Secretary, UniSource Energy Corporation,
One South Church Avenue, Suite 200, Tucson, Arizona
85701. The communications will be kept confidential and
forwarded to the Lead Director. Communications received
by the Lead Director will be forwarded to the
appropriate director(s) or to an individual
non-management director.
Shareholders or other interested parties wishing to
communicate with the Board regarding non-financial
matters may contact the Chairperson of the Corporate
Governance and Nominating Committee either by mail,
addressed to
8
Chairperson, Corporate Governance and Nominating
Committee, UniSource Energy Corporation, P. O. Box
30430, Tucson, Arizona 85751-0430, or by e-mail at
unscorpgov@earthlink.net. Shareholders or other
interested parties wishing to communicate with the
Board regarding financial matters may contact the
Chairperson of the Audit Committee either by mail,
addressed to Chairperson, Audit Committee, UniSource
Energy Corporation, P.O. Box 191191, Atlanta,Georgia
31119, or by e-mail at unscorpaudit@earthlink.net.
Items that are unrelated to a director's duties and
responsibilities as a Board member may be excluded from
consideration, including, without limitation,
solicitations and advertisements, junk mail,
product-related communications, job referral materials
such as resumes, surveys and material that is determined
to be illegal or otherwise inappropriate.
Board Committees THE AUDIT COMMITTEE reviews current and projected
financial results of operations, selects a firm of
independent registered public accountants to audit our
financial statements annually, reviews and discusses the
scope of such audit, receives and reviews the audit
reports and recommendations, transmits its
recommendations to the Board, reviews our accounting and
internal control procedures with our internal audit
department from time to time, makes recommendations to
the Board for any changes deemed necessary in such
procedures and performs such other functions as
delegated by the Board. Our Audit Committee held 11
meetings in 2004 and was in full compliance with its
written charter, as amended on October 5, 2004 and
attached to this Proxy Statement as Appendix A.
Upon the recommendation of the Audit Committee, our
Board adopted a code of ethics for our directors,
officers and employees.
THE COMPENSATION COMMITTEE reviews the performance of
our directors and officers and reviews and approves
directors' and officers' compensation. Our Compensation
Committee held three meetings in 2004 and was in full
compliance with its written charter.
THE FINANCE COMMITTEE reviews and recommends to the
Board long-range financial policies, objectives and
actions required to achieve those objectives.
Specifically, the Finance Committee reviews capital and
operating budgets, current and projected financial
results of operations, short-term and long-range
financing plans, dividend policy, risk management
activities and major commercial banking, investment
banking, financial consulting and other financial
relations of UniSource Energy. Our Finance Committee
held three meetings in 2004 and was in full compliance
with its written charter.
THE CORPORATE GOVERNANCE AND NOMINATING COMMITTEE
reviews and recommends corporate governance principles,
interviews potential directors and nominates and
recommends to the shareholders and directors, as the
case may be, qualified persons to serve as directors.
The Corporate Governance and Nominating Committee also
reviews and recommends membership for all the committees
to the Board and reviews applicable rules and
regulations relating to
9
the duties and responsibilities of the Board. The
Corporate Governance and Nominating Committee held two
meetings in 2004 and was in full compliance with its
written charter.
The Corporate Governance and Nominating Committee
identifies and considers nominee candidates supplied by
shareholders and Board members. The Corporate Secretary,
as directed by the Corporate Governance and Nominating
Committee, prepares portfolios for nominee candidates
that include confirmation of the candidate's interest,
independence, biographical information, review of
business background and experience and reference checks.
The Corporate Governance and Nominating Committee then
evaluates candidates using, in large part, the criteria
set forth in the next paragraph and any other criteria
the Committee deems appropriate, and conducts a personal
interview with each candidate. Upon completion of this
process, formal invitations are extended to accept
election to the Board.
The Corporate Governance and Nominating Committee has
not adopted specific minimum qualifications with respect
to a Committee-recommended Board nominee, but desirable
qualifications are set forth in the Board manual and
include prior community, professional or business
experience that demonstrates leadership capabilities,
the ability to review and analyze complex business
issues, the ability to effectively represent the
interests of our shareholders while keeping in
perspective the interests of our customers, the ability
to devote the time and interest required to attend and
fully prepare for all regular and special Board
meetings, the ability to communicate and work
effectively with the other Board members and personnel
and the ability to fully adhere to any applicable laws,
rules or regulations relating to the performance of a
director's duties and responsibilities.
While no formal policy exists, the Corporate Governance
and Nominating Committee does consider recommendations
for Board nominees received from our shareholders. The
deadline for consideration of recommendations for next
year's annual meeting of the shareholders is December 7,
2005. Recommendations must be in writing and include
detailed biographical material indicating the
candidate's qualifications and a written statement from
the candidate of willingness and availability to serve.
Recommendations should be directed to the Corporate
Secretary, UniSource Energy Corporation, One South
Church Avenue, Suite 200, Tucson, Arizona 85701. The
Board will consider nominees on a case-by-case basis and
does not believe a formal policy is warranted at this
time due to a manageable volume of nominations.
Each member of our Audit Committee, Compensation
Committee and Corporate Governance and Nominating
Committee is independent based upon independence
criteria established by our Board, which criteria are in
compliance with applicable NYSE listing standards.
10
Copies of A copy of the Audit, Compensation and Corporate
Charters, Governance and Nominating Committee Charters, as well as
Guidelines and our Corporate Governance Guidelines and code of ethics,
Code of Ethics are available on our Web site at www.unisourceenergy.com
or may be obtained by shareholders, without charge, upon
written request to Library and Resource Center,
UniSource Energy Corporation, 3950 East Irvington Road,
Mail Stop RC114, Tucson, Arizona 85714.
BOARD COMPENSATION
Retainer and Fees In 2004, each non-employee director received a $20,000
annual cash retainer, $1,000 for each Board meeting
attended, $1,000 for each committee meeting attended
and an additional $1,000 per committee meeting if
acting as a committee chairperson. We reimburse
directors for any expenses related to their Board and
committee service.
Effective for 2005, a Chairmanship retainer replaces
the additional $1,000 per committee meeting previously
paid to the committee chairman. The annual Chairmanship
retainer for the Audit Chairman is $20,000. The annual
Chairmanship retainer for all other Chairmanships,
including special committee chairmanships, is $15,000.
Chairmanship retainers will be credited to individual
Director accounts in the form of stock units and will
accrue dividend equivalent stock units. The stock units
will be distributed in cash in the year following
termination of Board service unless UniSource Energy
solicits and receives shareholder approval for a new
stock incentive plan, in which case the stock units may
be distributed in shares at the Board's or Compensation
Committee's discretion.
Option and Under the terms of the 1994 Outside Director Stock
Restricted Share Option Plan, each non-employee director in office on
Grants the first business day of each year, and who has been
a director for at least three months, is granted a
stock option covering a number of shares of our common
stock equal to $10,000 divided by the value of an
option as of the date of grant. In 2004, non-employee
directors received an award of restricted stock units
in lieu of stock options due to the impact of the
proposed merger on the market value of our common
stock. Restricted stock units vest in one-third
increments over three years.
Each non-employee director in office on the first
business day of each year is also granted a number of
restricted shares of our common stock equal to $10,000
divided by the then fair market value of a share of
our common stock. Restricted shares vest on the third
anniversary of the grant date.
On January 2, 2004, each of the non-employee directors
received 405 restricted stock units and 405 restricted
shares of our common stock.
Effective for 2005, the value of the equity
compensation component of non-employee director
compensation is increased from $20,000 to $40,000.
Because awards valued at $20,000 were made under the
1994 Outside Director Stock Option Plan in January
2005, a one-time award of restricted stock units equal
to $20,000 divided by the then fair market value of a
share of our common stock, will be made to each
non-employee director in office on May 6, 2005, the
date of the annual Shareholder Meeting. The awards will
vest over a one-year period and,
11
once vested, will accrue dividend equivalent stock
units. The stock units will be distributed in cash
in the year following termination of Board service
unless UniSource Energy solicits and receives
shareholder approval for a new stock incentive plan, in
which case the stock units may be distributed in shares
at the Board's or Compensation Committee's discretion.
Unvested awards are forfeited at termination other than
for disability or retirement.
DIRECTOR COMPENSATION FOR LAST FISCAL YEAR
Cash Compensation Security Grants
-------------------------------------- ---------------------------------------
Number of Shares Number of
Annual Subject to Securities
Retainer Meeting Restricted Stock Underlying Options
Name (1) Fee ($) (2) Fees ($) (2) Award
------------------- ----------- ---------------- ---------------- -----------------
Lawrence J. Aldrich 20,000 22,000 (3)(5) 810 0
Larry W. Bickle 20,000 20,000 (4)(5) 810 0
Elizabeth T. Bilby 20,000 27,000 (5) 810 0
Harold W. Burlingame 20,000 31,000 810 0
John L. Carter 20,000 48,000 (3)(4)(5) 810 0
Robert A. Elliott 20,000 30,000 810 0
Kenneth Handy 20,000 35,000 (3)(5) 810 0
Warren Y. Jobe 20,000 44,000 810 0
-------------------
(1) Mr. Pignatelli is not listed in this table because directors who are
officers of UniSource Energy or salaried employees of its subsidiaries do
not receive compensation in their capacity as members of the Board. Refer
to the Summary Compensation Table for information concerning his
compensation.
(2) Cash compensation includes amounts earned but deferred at the election of
directors.
(3) As members of the GSE board, Mr. Aldrich and Mr. Carter each received an
additional $2,000 and Mr. Handy received an additional $1,000 for attending
GSE board meetings during 2004. UniSource Energy owns 99% of GSE.
(4) As members of the IPS board, Mr. Bickle and Mr. Carter received an
additional $3,000 for attending IPS board meetings during 2004. UniSource
Energy owns 72% of IPS.
(5) As members of the UES board, Mr. Aldrich, Ms. Bilby, Mr. Carter and Mr.
Handy each received an additional $3,000 and Mr. Bickle received an
additional $2,000 for attending UES board meetings during 2004. UniSource
Energy owns 100% of UES.
12
EXECUTIVE COMPENSATION AND OTHER INFORMATION
Summary of The following table summarizes the compensation and
Compensation stock option grants to, and stock options/stock
appreciation rights ("SARs") held by, the Named
Executives.
SUMMARY COMPENSATION TABLE
Annual Compensation Compensation Awards
----------------------- ---------------------------------
Restricted Securities All Other
Name and Stock Awards Underlying Compensation
Principal Position Year Salary ($) Bonus ($) ($) (1) Options/SARs (#) ($) (2)
------------------ ---- ---------- --------- ----------- ---------------- ------------
James S. Pignatelli 2004 624,231 525,000 -- 0 13,000
Chairman, President and 2003 599,327 550,000 -- 21,226 12,000
Chief Executive Officer 2002 574,654 320,000 -- 150,000 11,000
Steven J. Glaser 2004 284,692 178,000 -- 0 9,225
Senior Vice President and Chief 2003 274,596 166,000 -- 9,729 11,232
Operating Officer, Transmission 2002 259,654 110,000 -- 45,000 11,000
& Distribution - TEP
Dennis R. Nelson 2004 274,846 137,000 -- 0 12,368
Senior Vice President and Chief 2003 269,732 150,000 -- 9,552 12,000
Operating Officer - UES 2002 260,000 90,000 -- 45,000 11,000
Michael J. DeConcini 2004 244,537 138,000 -- 0 11,004
Senior Vice President, 2003 229,192 145,000 -- 8,137 10,314
Investments and Planning / 2002 199,654 72,000 -- 40,000 11,000
Senior Vice President and Chief
Operating Officer, Energy
Resources - TEP
Kevin P. Larson 2004 229,692 130,000 -- 0 10,336
Vice President, Chief Financial 2003 219,462 145,000 -- 7,783 9,876
Officer and Treasurer 2002 199,656 76,000 -- 35,000 11,000
Vincent Nitido, Jr. 2004 229,692 130,000 -- 0 9,225
Vice President, General Counsel 2003 219,462 145,000 -- 7,783 9,876
and Chief Administrative Officer 2002 199,654 68,000 -- 40,000 11,000
-------------------
(1) As of December 31, 2004, based on the closing market price of UniSource
Energy's stock on that date of $24.11, Mr. Pignatelli held 110,915 stock
units (including dividend equivalent stock units) valued at $2,674,162; Mr.
Glaser held 28,003 stock units (including dividend equivalent stock units)
valued at $675,149; Mr. Nelson held 24,653 stock units (including dividend
equivalent stock units) valued at $594,372; Mr. DeConcini held 24,356 stock
units (including dividend equivalent stock units) valued at $587,232; and
Mr. Nitido held 16,374 stock units valued at $394,777.
(2) All Other Compensation is comprised of UniSource Energy's contributions to
the 401(k) Plan and Excess 401(k) contributions to the UniSource Energy
Corporation Management and Directors Deferred Compensation Plan.
13
Stock Option During 2004, the Compensation Committee of our Board
Grants in 2004 granted no stock options to officers.
Option and SAR The following table includes the number and value of
Holdings as of exercisable and non-exercisable options and SARs held
December 31, by the Named Executives as of December 31, 2004.
2004
AGGREGATED OPTION/SAR EXERCISES IN
LAST FISCAL YEAR AND FISCAL YEAR-END OPTION/SAR VALUES
Number of Securities
Underlying Unexercised Value of Unexercised
Shares Options/SARs at Fiscal In-the-Money Options/SARs at
Acquired Year-End (#) Fiscal Year End ($)
on Exercise Value Exercisable/ Exercisable/
Name (#) Realized($) Unexercisable Unexercisable(1)
--------------------- ----------- ----------- ---------------------- -----------------------------
James S. Pignatelli 7,424 $53,022 707,764 / 0 5,997,824 / 0
Steven J. Glaser 3,671 $28,256 186,201 / 0 1,476,105 / 0
Dennis R. Nelson 4,543 $37,380 178,988 / 0 1,492,992 / 0
Michael J. DeConcini 342 $2,849 135,008 / 0 1,082,951 / 0
Kevin P. Larson 2,014 $16,716 105,154 / 0 858,056 / 0
Vincent Nitido, Jr. 1,939 $15,882 139,654 / 0 1,111,732 / 0
-------------------
(1) Includes cash dividend equivalents on stock options awarded in 2002
under the 1994 UniSource Energy Corporation Omnibus Stock and Incentive
Plan.
2004 Long-Term The following table includes the number of shares,
Incentive Plan units or other rights awarded to the Named
Awards Executives in the last fiscal year under any
long-term incentive plan.
Payout of the 2004 long-term incentive plan awards
was based on the achievement, during the 2004
performance period, of three financial goals. The
three equally-weighted financial goals were UNS
earnings per share, TEP operating cash flow and UNS
consolidated operating cash flow. Threshold
performance is achieved at 80% of target, and
exceptional performance is achieved at 120% of
target.
14
LONG-TERM INCENTIVE PLANS
AWARDS IN LAST FISCAL YEAR
Number of Shares, Performance or Other Period Future Payouts under
Name Units or Other Rights (#) Until Maturation or Payout Non-Stock Price-Based Plans
Payable
(# or $) (1)
----------- ------------------------- --------------------------- ----------------------------
James S. Pignatelli 625,000 (2) 1/1/04 - 12/31/04 $625,000
Steven J. Glaser 285,000 (2) 1/1/04 - 12/31/04 $285,000
Dennis R. Nelson 275,000 (2) 1/1/04 - 12/31/04 $275,000
Michael J. DeConcini 245,000 (2) 1/1/04 - 12/31/04 $245,000
Kevin P. Larson 230,000 (2) 1/1/04 - 12/31/04 $230,000
Vincent Nitido, Jr. 230,000 (2) 1/1/04 - 12/31/04 $230,000
-------------------
(1) Based on the achievement of the three financial goals in 2004,
awards were granted at 120% of target. Payouts vest and become
payable in one-third increments on March 18, 2005, January 2006 and
January 2007.
(2) Performance units are denominated in cash. One performance unit
equals $1.00.
EQUITY COMPENSATION PLAN INFORMATION
Equity Our only equity-based compensation plan that has not
Compensation Plans been approved by shareholders is the Management and
Directors Deferred Compensation Plan (the "DCP").
Shareholder approval of the DCP has not been
required. Under the DCP, certain eligible officers
and other employees selected for participation, and
non-employee members of the Board, may elect to
defer a percentage of the compensation or fees that
would otherwise become payable to the individual for
their services to us. We also credit DCP accounts of
employees participating in our 401(k) Plan with the
additional amount of UniSource Energy matching
contributions that the participant would have been
entitled to under the 401(k) Plan if certain Code
limits did not apply to limit the amount of
UniSource Energy matching contributions made under
the 401(k) Plan. Each participant in the DCP may
elect that his or her deferrals be credited in the
form of deferred shares. Deferred shares are
bookkeeping entries that, when payable, will be paid
in the form of an equivalent number of shares of
UniSource Energy common stock. Deferred shares
accrue dividend equivalents, credited in the form of
additional deferred shares, as dividends are paid by
UniSource Energy on its issued and outstanding
common stock. Each participant elects the time and
manner of payment (lump sum or installments) of his
or her deferred shares under the DCP. The shares
used to satisfy our stock obligations under the DCP
are shares that have been purchased on the open
market.
15
EQUITY COMPENSATION PLAN TABLE
Equity The following table sets forth information as of
Compensation December 31, 2004, with respect to UniSource
Energy's equity compensation plans.
Number of Shares of Number of Shares of UniSource Energy
UniSource Energy Common Common Stock Remaining Available for
Stock to Future Issuance Under Equity
be Issued Upon Exercise Weighted-Average Compensation Plans (Excluding
of Outstanding Exercise Price of Shares Reflected
Plan Category Options and Rights Outstanding Options in the First Column
------------------------ ------------------------ --------------------- ---------------------------------
Equity Compensation Plans 2,328,674 (2) $16.19 (3) 983,175 (4)
Approved by Shareholders (1)
--
Equity Compensation Plans 55,951 (5) -- (6)
Not Approved by Shareholders
-- --
Total 2,384,625
-------------------
(1) The equity compensation plans approved by shareholders are the
UniSource Energy Corporation 1994 Omnibus Stock and Incentive
Plan and the UniSource Energy Corporation 1994 Outside Director
Stock Option Plan. Under the terms of the UniSource Energy
Corporation 1994 Omnibus Stock and Incentive Plan, no award may
be granted after February 3, 2004. The plan remains in effect
until all awards have expired or terminated or shall have been
exercised or fully vested, and any stock thereto shall have been
purchased or acquired.
(2) Includes options outstanding as to 2,075,552 shares, and stock
units, dividend equivalent stock units and restricted stock units
(payable in an equivalent number of shares) outstanding as to
253,122 shares.
(3) Calculated based on the outstanding options and exclusive of
outstanding stock units.
(4) Of these shares, 813,557 were available for additional awards
under the 1994 Omnibus Stock and Incentive Plan and 169,618 were
available for additional awards under the 1994 Outside Director
Stock Option Plan. Although 813,557 shares remained available for
grant under the 1994 Omnibus Stock and Incentive Plan, pursuant
to the plan document, no award may be granted under the Plan
after February 3, 2004. Shares available under either of these
plans may be used for any type of award authorized under that
plan. Awards authorized under the 1994 Omnibus Stock and
Incentive Plan include options, stock appreciation rights,
restricted stock, performance shares and stock units. Awards
authorized under the 1994 Outside Director Stock Plan include
options, restricted stock and dividend equivalents.
(5) Deferred shares credited under the DCP.
(6) There is no explicit share limit under the DCP. The number of
shares to be delivered with respect to the DCP in the future
depends on the levels of fees and compensation that participants
elect to defer under the DCP. The UniSource Energy shares used to
satisfy our stock obligations under the DCP are shares that have
been purchased on the open market.
Pension Plans The following table shows the estimated annual
retirement benefit payable to participants,
including the Named Executives, for the average
annual compensation and years of service indicated.
Compensation is comprised of the officers' average
annual compensation during the five consecutive
years of employment with the highest compensation
within the last 15 years preceding retirement.
Compensation is comprised of salary and bonus, as
shown on the Summary Compensation Table.
16
PENSION PLAN TABLE
Years of Service
---------------------------------------------------------------------------------------------
Remuneration ($) 10 15 20 25 30 35
-- -- -- -- -- --
125,000 54,850 54,850 54,850 54,850 54,850 54,850
150,000 65,820 65,820 65,820 65,820 65,820 65,820
175,000 76,790 76,790 76,790 76,790 76,790 76,790
200,000 87,760 87,760 87,760 87,760 87,760 87,760
225,000 98,730 98,730 98,730 98,730 98,730 98,730
250,000 109,700 109,700 109,700 109,700 109,700 109,700
300,000 131,640 131,640 131,640 131,640 131,640 131,640
400,000 175,520 175,520 175,520 175,520 175,520 175,520
450,000 197,460 197,460 197,460 197,460 197,460 197,460
500,000 219,400 219,400 219,400 219,400 219,400 219,400
550,000 241,340 241,340 241,340 241,340 241,340 241,340
600,000 263,280 263,280 263,280 263,280 263,280 263,280
650,000 285,220 285,220 285,220 285,220 285,220 285,220
700,000 307,160 307,160 307,160 307,160 307,160 307,160
750,000 329,100 329,100 329,100 329,100 329,100 329,100
800,000 351,040 351,040 351,040 351,040 351,040 351,040
850,000 372,980 372,980 372,980 372,980 372,980 372,980
900,000 394,920 394,920 394,920 394,920 394,920 394,920
950,000 416,860 416,860 416,860 416,860 416,860 416,860
1,000,000 438,800 438,800 438,800 438,800 438,800 438,800
1,100,000 482,680 482,680 482,680 482,680 482,680 482,680
1,200,000 526,560 526,560 526,560 526,560 526,560 526,560
1,300,000 570,440 570,440 570,440 570,440 570,440 570,440
1,400,000 614,320 614,320 614,320 614,320 614,320 614,320
The amount of the pension benefit is equal to a base of
40% of the compensation for ten years of service, plus
9.7% (life annuity factor) of such calculated amount. The
estimated benefits shown in the Pension Plan Table are
straight life annuities not subject to a reduction for any
Social Security benefits. The table also reflects amounts
payable under the Excess Benefits Plan which will pay from
the general funds of UniSource Energy the difference, if
any, between the benefits under TEP's pension plan and any
benefit payments, which may be limited by federal
regulations.
17
The credited years of service for UniSource Energy's Named
Executives are as follows:
Credited
Name Years of Service
------------------- ----------------
James S. Pignatelli 10
Steven J. Glaser 15
Dennis R. Nelson 27
Michael J. DeConcini 16
Kevin P. Larson 19
Vincent Nitido, Jr. 14
OFFICER CHANGE IN CONTROL AGREEMENTS
Change in Control TEP has Change in Control Agreements ("Agreements")
Agreements were with all of its officers. The Agreements are in
adopted to effect until the later of: (i) five years after the
attract and date either TEP or the officer gives written notice
retain quality of termination of the Agreement, or (ii) if a change
management. in control occurs during the term of the Agreement,
five years after the change in control. On March 29,
2004, a change in control occurred for purposes of
the Agreements when our shareholders, at a special
meeting, approved the acquisition agreement that
provided for an affiliate of Saquaro Utility Group
L.P. to acquire all of our outstanding shares of
common stock. This was not affected by the fact that
the acquisition was ultimately not consummated.
For the purpose of the Agreements, a change in
control includes the acquisition of beneficial
ownership of 30% of the common stock of UniSource
Energy, certain changes in the UniSource Energy
Board of Directors, approval by the shareholders of
certain mergers or consolidations or certain
transfers of the assets of UniSource Energy. The
Agreements provide that each officer shall be
employed by TEP, or one of its subsidiaries or
affiliates, in a position comparable to his or her
current position, with compensation and benefits,
which are at least equal to their then current
compensation and benefits, for an employment period
of five years after a change in control (subject to
earlier termination due to the officer's acceptance
of a position with another company or termination
for cause).
In the event that the officer's employment is
terminated by TEP (with the exception of
termination due to the officer's acceptance of
another position or for cause), or if the officer
terminates employment because of a reduction in
position, responsibility, compensation or for
certain other stated reasons, the officer is
entitled to severance benefits in the form of: (i)
a lump sum payment equal to the present value of
three times annual salary and bonus compensation,
(ii) the present value of the additional amount the
officer would have received under the TEP
Retirement Plan if the officer had continued to be
employed for the five-year period after a change in
control occurs, plus (iii) the present value of any
employee awards under the 1994 Omnibus Stock and
Incentive Plan or any successor plan, which are
outstanding at the time of the officer's
termination (whether vested or not), prorated based
on length of service. Such officer is also entitled
to continue to participate in TEP's health, death
and disability benefit plans for five years after
the termination. The Agreements further provide
that TEP will make a payment to the officer to
offset any excise taxes that may become payable
under certain conditions. Any payments made in
respect of such excise taxes are not deductible by
us. Assuming Mr. Pignatelli's and the other Named
18
Executives' employment was terminated, the total
payments made by UniSource Energy pursuant to the
Agreements would not be expected to exceed $20
million.
On March 3, 2005, TEP provided the officers with
respect to which the Agreements were in effect at
that time, written notice of termination of the
Agreements. Pursuant to the terms of the
Agreements, the termination will become effective
on March 3, 2010, the fifth anniversary of the date
of the written notice of termination.
DIRECTOR INDEPENDENCE CRITERIA
Board independence The Board has established the following criteria for
is determined by determining independence, among other things, in
consideration of order to determine eligibility to serve on the Audit
established Committee, the Compensation Committee and the
criteria. Corporate Governance and Nominating Committee.
Directors that meet each of the following criteria
are deemed independent:
1. A director who is an employee of the Company
or whose immediate family member is an
executive officer of the Company cannot be
"independent" until three years after the
employment has ended. Employment as an interim
Chairman or CEO shall not disqualify a director
from being considered independent following
that employment.
2. A director who is, or in the past three years
has been, affiliated with or employed in a
professional capacity by a present or former
internal or external auditor of the Company or
whose immediate family member is, or in the
past three years has been, affiliated with or
employed in a professional capacity by a
present or former internal or external auditor
of the Company cannot be "independent" until
three years after the end of the affiliation,
employment or auditing relationship.
3. A director who is employed, or whose
immediate family member is employed, as an
executive officer of another company where any
of the Company's present executives serve on
that company's compensation committee is not
"independent" until three years after the end
of such service or the employment relationship.
4. A director who receives, or whose immediate
family member receives, more than $100,000 per
year in direct compensation from the Company,
other than director and committee fees and
pension or other forms of deferred compensation
for prior service (provided such compensation
is not contingent in any way on continued
service), is not independent until three years
after he or she ceases to receive more than
$100,000 per year in such compensation.
19
Compensation received by a director for former
service as an interim Chairman or CEO need not
be considered in determining independence.
Compensation received by an immediate family
member for service as a non-executive employee
of the Company need not be considered in
determining independence under this test.
5. A director who is an executive officer or an
employee, or whose immediate family member is
an executive officer, of a company that makes
payments to, or receives payments from, the
Company for property or services in an amount
which, in any single fiscal year, exceeds the
greater of $1 million or 2% of such other
company's consolidated gross revenue, is not
"independent" until three years after falling
below such threshold.
6. Directors who possess an interest in any
transaction for which disclosure would be
required pursuant to Item 404(a) of SEC
Regulation S-K (generally, this item requires
proxy statement disclosure of transactions
exceeding $60,000 between a director and the
Company or any of our subsidiaries) are not
independent.
7. Directors that do not meet item 6 of the
aforementioned criteria may nonetheless be
deemed independent by a majority of independent
directors, provided the basis for such
determination shall be disclosed in the
Company's Proxy Statement.
Based upon the foregoing criteria, the Board has
deemed each director to be independent, with the
exceptions of Mr. Aldrich, Mr. Bickle, Ms. Bilby and
Mr. Pignatelli. See "Transactions with Management and
Others" below.
TRANSACTIONS WITH MANAGEMENT AND OTHERS
Haddington Millennium was authorized by its Board of Directors in
Energy 2000 to invest $15 million, in aggregate, over a three-
Partners II LP to five-year period in Haddington Energy Partners II
LP. Mr. Bickle, a member of our Board, is the managing
director of Haddington Ventures LLC, the general
partner of Haddington Energy Partners II LP. As of
December 31, 2004, Millennium had funded approximately
$10.9 million under this commitment, $2.4 million of
which was funded in 2004.
Valley Ventures III, In 2000, Millennium made a commitment of $5 million in
LP capital plus a share of expenses to Tucson Ventures,
LLC, a venture capital fund. In 2002, Tucson Ventures,
LLC merged with Valley Ventures III, LP, also a venture
capital fund. In connection with the merger of the
funds, Millennium's commitment was revised to a total
of $6 million, including expenses. Mr. Aldrich, a
member of our Board, is a general partner of the
company that manages Valley Ventures III, LP. As of
December 31, 2004, Millennium had funded approximately
$3.3 million under this commitment.
Millennium Energy Mr. Stephen Alexander, an immediate family member of
Investments Ms. Bilby, a member of our Board, is employed by
Millennium. As Director of Energy Investments, Mr.
Alexander assists in overseeing Millennium's investment
portfolio. For his services in 2004, Mr. Alexander
received compensation of approximately $150,000 from
Millennium.
20
COMPENSATION COMMITTEE REPORT ON EXECUTIVE COMPENSATION
The Committee The Compensation Committee is responsible for
developing and administering executive compensation
policies and programs for UniSource Energy and TEP
and making recommendations to the Board with respect
thereto. The Compensation Committee makes
recommendations to the Board with respect to the
compensation of UniSource Energy's executive
officers, including Mr. Pignatelli and the other
Named Executives, and sets policies for and reviews
the compensation awarded to other key members of
management. UniSource Energy applies a consistent
philosophy to compensation for all executive
employees, including the Named Executives.
Overall Objectives UniSource Energy's executive compensation policies
and programs generally are intended to (i) relate the
compensation of employees to the success of UniSource
Energy and the corresponding creation of shareholder
value and deliver rewards for superior performance
and consequences for underperformance and (ii)
attract, retain and motivate executives and key
employees with competitive compensation opportunities.
Executive The Compensation Committee reviews our executives'
Compensation compensation each year. Compensation depends on many
Generally factors, including individual performance,
responsibilities, future challenges and objectives
and the executive's potential contribution to our
future success. The Compensation Committee also looks
at our financial performance and the compensation
levels at comparable companies.
UniSource Energy's 2004 compensation program
consisted of three components:
o base salary;
o short-term incentive compensation; and
o long-term incentive compensation.
Base Salary The base salary component of compensation is intended
to be competitive with that paid by comparable
companies in the energy industry. In developing the
compensation program, the Compensation Committee
retained an external consultant to conduct a
competitive analysis of pay for UniSource Energy's
officer group. In conducting its analysis for 2004,
the consultant selected a peer group of energy
companies with a revenue range of $585 million to
$1.6 billion. UniSource Energy ranks at the 33rd
percentile of the peer group. The peer group
companies were selected based on (i) similarity to
UniSource Energy in terms of business sector (i.e.,
electric services and natural gas distribution
companies) and (ii) comparable size to UniSource
Energy in terms of sales and market capitalization.
The Compensation Committee believes that the
companies in the peer group are a more appropriate
comparison for UniSource Energy than the Edison
Electric 100 companies used in the Performance Graph
on page 27 of this Proxy Statement because the
type of business, annual revenues and market
capitalization of the companies included in the
survey are more closely related to those of
UniSource Energy and the companies in the peer
group are primary competitors of UniSource Energy
for top-level management personnel. The
external data from companies in the peer group was
used to develop market compensation for each
executive position. "Market compensation" refers to
the median salary for executives in the peer group.
Base salaries for UniSource Energy's executive
officers, including Mr. Pignatelli and the other
21
Named Executives, were set at market compensation
levels in January 2004, in recognition of the
increasingly competitive environment in the electric
industry, the need to continue to attract and retain
highly qualified executives and the fact that a
substantial portion of each executive's total
compensation package is "at-risk," based on the
achievement of certain corporate goals. See
"Short-Term Incentive Compensation and Long-Term
Incentive Compensation" below.
Short-Term The Board adopted a Short-Term Incentive Plan to
Incentive provide compensation for meeting or exceeding
Compensation specified objectives, designed to contribute to the
attainment of UniSource Energy's performance targets
and long-term strategic plan. Under the Short-Term
Incentive Plan, target award levels are set as a
percentage of each participant's base salary. In
2004, the target award levels for our executive
officers ranged from 30% to 70% of base salary.
Awards for Mr. Pignatelli and the remaining executive
officers are determined by the Board based on the
achievement of corporate financial goals, including
earnings per share and consolidated cash flow, and
the accomplishment of previously established
individual goals and contribution to business
results. Based on the foregoing factors, the
Compensation Committee made awards to the Named
Executives ranging from 56% to 84% of base salary. In
determining Mr. Pignatelli's award, the Compensation
Committee focused on the achievement of previously
established strategic, financial, operating and
community goals. Incentive compensation awarded to
Mr. Pignatelli and the other Named Executives is set
forth in the preceding Summary Compensation Table.
Long-Term UniSource Energy's long-term incentive compensation
Incentive is intended to attract and retain quality employees
Compensation over the long-term in a manner that directly aligns
their interests with those of UniSource Energy's
shareholders and promote UniSource Energy's long-term
performance goals.
On February 5, 2004, the Compensation Committee
awarded performance units (denominated in cash) to
all executive officers of UniSource Energy, including
Mr. Pignatelli and the other Named Executives. In
calculating the level of awards to the executive
officers, the Compensation Committee considered the
above analysis of executive compensation at
comparative companies. Based on such analysis, the
Compensation Committee awarded Mr. Pignatelli and the
other Named Executives performance units with a total
value equal to 100% of base salary for target
performance. The number of performance units awarded
to Mr. Pignatelli was 625,000. See "2004 Long-Term
Incentives Plan Awards" on page 14 of this Proxy
Statement for a discussion of the performance
criteria upon which the payout of performance units
is dependent. In determining the 2004 long-term
incentive awards, the Compensation Committee did not
consider awards, including stock options, previously
granted or outstanding.
22
The Compensation Committee believes that senior
management should have a significant equity interest
in UniSource Energy. In order to promote equity
ownership and further align the interests of
management with those of UniSource Energy's
shareholders, the Compensation Committee adopted
share retention and ownership guidelines for senior
management at its February 3, 2005 meeting. Under
these guidelines certain executives are expected to
maintain a significant ownership position in
UniSource Energy common stock, expressed as a
multiple of their salary as follows:
o Chairman, President and
Chief Executive Officer 5 times salary
o Senior Vice President 3 times salary
o Other Vice President 1 times salary
The Compensation Committee periodically reviews share
ownership levels of the persons subject to these
guidelines. The following types of shares count
towards meeting the specified ownership levels: (i)
shares owned outright, jointly with spouse, or in trust
for the executive's benefit, (ii) shares held in
qualified retirement and savings plans and (iii) stock
units payable in shares held in nonqualified deferred
compensation accounts. Nine of the ten executives
subject to these guidelines have achieved shareholdings
in excess of the applicable multiple set forth
above.
Tax Code Concerns The Compensation Committee does not presently have a
policy regarding qualifying compensation paid to
executive officers for deductibility under Section
162(m) of the Code.
Respectfully submitted,
THE COMPENSATION COMMITTEE
Harold W. Burlingame, Chair
John L. Carter
Robert A. Elliott
Kenneth Handy
Warren Y. Jobe
23
AUDIT COMMITTEE REPORT
The Committee The Audit Committee is made up of five financially
literate directors who are independent based upon
independence criteria established by our Board, which
criteria are in compliance with applicable NYSE listing
standards. Our Board has determined that while each
member of the Audit Committee has accounting and/or
related financial management expertise, Mr. Jobe is the
Audit Committee financial expert for the purposes of Item
401(h) of SEC Regulation S-K. In addition to Mr. Jobe,
there are two other financial experts on the Committee.
Each financial expert is independent as that term is used
in Item 7(d)(3)(iv) of Schedule 14A under the Securities
and Exchange Act of 1934. The Board previously adopted a
written charter for the Audit Committee. On October 5,
2004, the Board approved amendments to the Charter. The
Audit Committee Charter is included as Appendix A to this
Proxy Statement. The Committee has complied with its
charter, including the requirement to meet periodically
with our independent auditors, internal audit department
and management to discuss the auditors' findings and
other financial and accounting matters.
In connection with our December 31, 2004 financial
statements, the Audit Committee has (i) reviewed and
discussed the audited financial statements with
management, (ii) discussed with PricewaterhouseCoopers,
LLP, our independent auditor, the matters required to be
discussed by SAS 61 (Codification of Statements on
Auditing Standards, AU Sec. 380), (iii) received from
PricewaterhouseCoopers, LLP the written disclosures and
the letter required by Independence Standards Board
Standard No. 1 (Independence Discussions with Audit
Committees) and (iv) discussed with
PricewaterhouseCoopers, LLP its independence.
Based on all of its activities during the year, the Audit
Committee recommended to the Board that the audited
financial statements for 2004 be included in the Annual
Report on Form 10-K for filing with the SEC.
Pre-Approved Rules adopted by the SEC in order to implement
Policies and requirements of the Sarbanes-Oxley Act of 2002 require
Procedures public company audit committees to pre-approve audit and
non-audit services. Our Audit Committee has adopted a
policy pursuant to which audit, audit-related, tax and
other services are pre-approved by category of service.
Recognizing that situations may arise where it is in our
best interest for the auditor to perform services in
addition to the annual audit of our financial statements,
the policy sets forth guidelines and procedures with
respect to approval of the four categories of service
designed to achieve the continued independence of the
auditor when it is retained to perform such services for
us. The policy requires the Audit Committee to be
informed of each service and does not include any
delegation of the Audit Committee's responsibilities to
management. The Audit Committee may delegate to the
Chairman of the Audit Committee the authority to grant
pre-approvals of audit and non-audit services requiring
Audit Committee
24
approval where the Audit Committee Chairman believes it
is desirable to pre-approve such services prior to the
next regularly scheduled Audit Committee meeting. The
decisions of the Audit Committee Chairman to pre-approve
any such services from one regularly scheduled Audit
Committee meeting to the next shall be reported to the
Audit Committee.
Fees The following table details fees paid to
PricewaterhouseCoopers, LLP for professional services
during 2003 and 2004. The Audit Committee has considered
whether the provision of services to us by
PricewaterhouseCoopers, LLP, beyond those rendered in
connection with their audit and review of our financial
statements, is compatible with maintaining their
independence as auditors.
2003 2004
-------- ----------
Audit Fees $903,566 $2,190,556
Audit-Related Fees $644,744 $76,583
Tax Fees $98,645 $2,002
All Other Fees $2,598 $3,228
Audit fees include fees for the audit of our consolidated
financial statements included in our Annual Report on
Form 10-K and review of financial statements included in
our Quarterly Reports on Form 10-Q. Audit fees also
include services provided by PricewaterhouseCoopers, LLP
in connection with the audit of the effectiveness of
internal control over financial reporting and on
management's assessment of the effectiveness of internal
control over financial reporting, comfort letters,
consents and other services related to SEC matters and
financing transactions, statutory and regulatory audits,
and accounting consultations to the extent necessary for
PricewaterhouseCoopers, LLP to fulfill their
responsibilities under generally accepted auditing
standards. Audit fees in connection with the audit of the
effectiveness of internal control over financial
reporting and on management's assessment of the
effectiveness of internal control over financial
reporting in compliance with Sarbanes-Oxley totaled
$1,395,841 (already included in Audit Fees in the table
above) in 2004.
Audit-related fees during 2004 principally include fees
for employee benefit plan audits and due diligence-type
services related to proposed acquisitions. During 2003,
audit-related fees related primarily to the audits of the
gas and electric system assets acquired from Citizens
Communications Company on August 11, 2003 (for periods
prior to the acquisition date) and audits of employee
benefit plans.
Tax fees include tax compliance, tax advice and tax
planning.
All other fees consist of fees for all other services
other than those reported above and, in 2003 and 2004,
principally include subscription fees for research tools.
25
All services performed by PricewaterhouseCoopers, LLP are
approved in advance by the Audit Committee in accordance
with the Audit Committee's pre-approval policy for
services provided by the independent auditor.
Respectfully submitted,
THE AUDIT COMMITTEE
Warren Y. Jobe, Chair
Harold W. Burlingame
John L. Carter
Robert A. Elliott
Kenneth Handy
26
PERFORMANCE GRAPH
Comparison of Cumulative Five-Year Total Return Among
UniSource Energy, Standard & Poor's 500 Index
and EEI Index of 64 Investor-Owned Utilities (1)
The graph showing on the hard copy represents the comparison of four year
cumulative total return between UniSource Energy Corporation, the S&P 500
Index, and EEI Index of 100 investor-owned utilities. The graph's X-axis
shows the years 1999 to 2004, and the Y-axis shows dollar values from zero
to 250. The data points are connected by lines with the following markers:
UniSource Energy Corporation - triangles; S&P 500 - diamonds; EEI Index -
100 Electrics - squares. The data points are as follows:
1999 2000 2001 2002 2003 2004
---- ---- ---- ---- ---- ----
UniSource Energy
Corporation $100 $172 $170 $166 $243 $244
S&P 500 Index $100 $148 $135 $115 $142 $175
EEI Index - 100
Electrics $100 $91 $80 $62 $80 $88
(1) Assumes $100 invested on December 31, 1998 in UniSource Energy common
stock, S&P Index and EEI Index. It is assumed that all dividends are
reinvested in stock at the frequency paid and the returns of each
component peer group issuer are weighted according to the issuer's
stock market capitalization at the beginning of the period.
Data and Calculations 2000 2001 2002 2003 2004
-------------------------------- ----- ------ ------ ----- -----
S&P 500 Total Return Change -9.10% -11.89% -22.10% 28.69% 8.99%
EEI Index - 64 Electrics Change 47.97% -8.79% -14.73% 23.48% 22.84%
UniSource Energy Change 71.80% -1.30% -2.20% 46.72% 0.37%
27
SUBMISSION OF SHAREHOLDER PROPOSALS
General Rule 14a-4 of the SEC's proxy rules allows us to use
discretionary voting authority to vote on a matter coming
before an annual meeting of our shareholders, which was
not included in our Proxy Statement (if we do not have
notice of the matter at least 45 days before the date on
which we first mailed our proxy materials for the prior
year's annual meeting of the shareholders). In addition,
we may also use discretionary voting authority if we
receive timely notice of such matter (as described in the
preceding sentence) and if, in the Proxy Statement, we
describe the nature of such matter and how we intend to
exercise our discretion to vote on it. Accordingly, for
our 2006 annual meeting of shareholders, any such notice
must be submitted to the Corporate Secretary of UniSource
Energy on or before February 20, 2006.
We must receive This requirement is separate and apart from the SEC's
your shareholder requirements that a shareholder must meet in order to
proposals by have a shareholder proposal included in our Proxy
December 7, 2005. Statement. Shareholder proposals intended to be
presented at our 2006 annual meeting of the shareholders
must be received by us no later than December 7, 2005,
in order to be eligible for inclusion in our Proxy
Statement and the form of proxy relating to that meeting.
Direct any proposals, as well as related questions, to the
undersigned.
OTHER BUSINESS
The Board knows of no other matters for consideration at
the Meeting. If any other business should properly arise,
the persons appointed in the enclosed proxy have
discretionary authority to vote in accordance with their
best judgment.
Copies of our 2004 Annual Report on Form 10-K may be
obtained by shareholders, without charge, upon written
request to Library and Resource Center, UniSource Energy
Corporation, 3950 East Irvington Road, Mail Stop RC114,
Tucson, Arizona 85714. You may also obtain our SEC
filings through the Internet at www.sec.gov or
www.UniSourceEnergy.com.
By order of the Board of Directors,
/s/ Catherine A. Nichols
------------------------
Catherine A.Nichols
Corporate Secretary
PLEASE VOTE - YOUR VOTE IS IMPORTANT
28
APPENDIX A
Amended
October 5, 2004
UNISOURCE ENERGY CORPORATION
AUDIT COMMITTEE OF THE BOARD OF DIRECTORS
CHARTER
1. COMPOSITION
The Audit Committee of the Board of Directors (the "Committee") consists of
no fewer than three independent Directors appointed annually by the Board.
Directors eligible to serve on the Committee shall be determined in
accordance with the NYSE Listed Company Manual, Corporate Governance
Standards for Audit Committees and the Sarbanes-Oxley Act of 2002. The
Board shall designate one of the Committee members as Chairman of the
Committee. Each member of the Committee shall be financially literate, and
at least one member shall have accounting or financial management
expertise.
2. MEETINGS
The Committee will hold at least four regular meetings each year, and such
additional meetings as it may deem necessary. Additional meetings will be
called by the Chairman of the Committee. The agendas for the regular
meetings shall include all items necessary to complete the duties of the
Committee as set forth herein. In addition to the Committee members and the
Secretary, the Chairman of the Board, Chief Executive Officer and other
members of management, internal audit and representatives of the
independent auditors may attend as appropriate.
3. RULES OF PROCEDURE
The Committee will determine its own rules of procedure with respect to how
its meetings are to be called, as well as the place and time.
4. COMPENSATION
Each member will be paid such fees as may be established from time to time
by the Board for service on the Committee, and will be reimbursed for
travel expenses incurred by attendance at meetings. Directors' fees are the
only compensation an Audit Committee member may receive from the Company.
A-1
5. COMMITTEE SECRETARY
The Secretary of the Committee will be the Corporate Secretary of the
Company (or such other representative of management as the Committee may
designate) and not be a member of the Committee. The Secretary will attend
all meetings and maintain minutes, advise members of all meetings called,
arrange with the Chairman or other convening authority for preparation and
distribution of the agenda for each meeting, and carry out other functions
as may be assigned from time to time by the Committee. At such meetings
where attendance by a Company representative is not appropriate, the
Chairman shall act as secretary of the meeting or appoint another member of
the Committee to act as secretary of such meetings.
6. QUORUM
A majority of the total membership of the Committee will constitute a
quorum.
7. COMMITTEE PURPOSE
The Audit Committee is appointed by the Board to assist with Board
oversight of (1) the integrity of the Company's financial statements (2)
the Company's compliance with legal and regulatory requirements (3) the
independent auditor's qualifications and independence, and, (4) the
performance of the Company's internal audit function and independent
auditors.
The Audit Committee must also prepare the report that SEC rules require be
included in the Company's annual proxy statement.
8. SPECIFIC DUTIES OF THE COMMITTEE
Independent Audit:
------------------
(1) Sole authority to appoint, retain and terminate the Company's
independent auditor.
(2) Sole authority to approve all audit engagement fees and terms, as
well as all significant, non-audit engagements (in accordance with
SEC) with the independent auditors.
(3) Annually obtain and review a report from the independent auditors
delineating all relationships between the auditor and the Company
(to assess the auditors' independence).
(4) Review the experience and qualifications of the lead partner of
the independent auditor.
(5) Ensure the rotation of the audit partner(s) as required by law.
(6) At least annually, obtain and review a report from the independent
auditors describing the firm's internal quality control process,
including any material issues raised by the most recent internal
quality control review or peer review of the firm, or by any
inquiry or investigation by governmental, regulatory or
professional authorities within the past five years, respecting
one or more independent audits carried out by the firm, and any
steps taken to deal with any such issues.
A-2
(7) Review the results of each independent audit, including any
qualifications in the independent auditor's opinion, any related
management letter, and management's response to recommendations
made by the independent auditor in connection with the audit.
(8) Review the annual audited financial statements with management and
the independent auditor, including management's discussion and
analysis, major issues regarding accounting and auditing
principles and practices, as well as the adequacy of internal
controls. Recommend to the Board, based on such review and
discussion, whether the audited financial statements should be
included in the Company's annual report on Form 10-K.
(9) Annually review an analysis prepared by management and the
independent auditor of significant financial reporting issues,
quality of financial reporting, and judgments made in connection
with the preparation of the Company's financial statements,
including an analysis of the effect of alternative GAAP methods on
the Company's financial statements. Review the procedures employed
by the Company in preparing published financial statements and
related management commentaries.
(10) Review with management and the independent auditor the Company's
quarterly financial statements prior to the filing of its Form
10-Q, including management's discussion and analysis and the
results of the independent auditors' review of the quarterly
financial statements (SAS 90). Note: This can be performed by a
member of the Audit Committee.
(11) Discuss annually with the independent auditor the required
communications contained within Statement on Auditing Standards
No. 61 relating to the conduct of the audit.
(12) Discuss with the independent auditor material issues on which the
national office of the independent auditor was consulted by the
Company's audit team.
(13) Meet with the independent auditor prior to the audit to discuss
the planning and staffing of the audit.
Internal Audit:
---------------
(14) Review the appointment, replacement, reassignment or dismissal of
the Company's General Auditor.
(15) Review and approve the internal audit department charter, annual
audit plan and the audit methodology.
(16) Review management and General Auditor reports submitted to the
Committee that are material to the Company as a whole, and
management's response to those reports.
(17) Annually review the General Auditor's Summary of Officer's Annual
Travel and Entertainment expense schedule. Include in this review
a discussion of perquisites.
A-3
Miscellaneous:
--------------
(18) Review earnings press release as well as financial information and
earnings guidance provided to analysts and ratings agencies.
(19) Review quarterly updates from management on material litigation.
(20) Periodically review with management, the Company's policies on
major financial risk exposure, and the measures taken to reduce
such risk.
(21) Annually review the Company's Corporate Code of Conduct and
compliance therewith.
(22) Establish and maintain procedures for the confidential, anonymous
submission by employees of the Company of concerns regarding
accounting or auditing matters.
(23) Establish guidelines for the Company's hiring of employees or
former employees of the independent auditor.
(24) Annually review this Audit Committee Charter and make any
necessary changes.
(25) Annually perform an evaluation of the Committee, its members,
functions and performance.
(26) Review disclosures made by the Company's CEO and CFO during their
certification process for the Form 10-K and Form 10-Q about any
significant deficiencies in the design or operation of internal
controls or material weaknesses therein and any fraud involving
management or other employees who have a significant role in the
Company's internal controls.
9. EXECUTIVE SESSION
Meet quarterly with management, the General Auditor and the independent
auditor in separate executive sessions.
10. RESPONSIBILITIES OF THE CHAIRMAN
The Chairman of the Committee will present the Committee's recommendations
to the Board for its approval and periodically provide the Board, for its
information, with a summary of the Committee's determinations and
approvals. Additionally, set the annual compensation for the General
Auditor in conjunction with the Company's Chief Executive Officer.
A-4
11. RESPONSIBILITIES OF THE CHIEF EXECUTIVE OFFICER
The Chief Executive Officer of the Company will advise and make
recommendations to the Committee and, in the normal course, attend all
meetings of the Committee.
12. OTHER AUTHORITY
The Audit Committee shall have the authority to retain special legal,
accounting or other consultants to advise the Committee. The Audit
Committee has full discretion to meet with individuals within or outside
the Company.
A-5
APPENDIX B
FORM OF PROXY CARD
UNISOURCE ENERGY
YOUR VOTE IS IMPORTANT
VOTE BY TELEPHONE OR INTERNET
24 HOURS A DAY - 7 DAYS A WEEK
INTERNET
--------
https://www.proxyvotenow.com/uns
- Go to the website address listed above.
- Have your proxy card ready.
- Follow the simple instructions that appear on
your computer screen.
OR
TELEPHONE
---------
1-866-358-4695
- Use any touch-tone telephone.
- Have your proxy card ready.
- Follow the simple recorded instructions.
OR
MAIL
----
- Mark, sign and date your proxy card.
- Detach your proxy card.
- Return your proxy card in the postage-paid envelope provided.
You can vote your shares by telephone, the Internet, mail or in person at
the Annual Shareholders' Meeting. Your telephone or Internet vote authorizes
the named proxies to vote your shares in the same manner as if you marked,
signed and returned your proxy card. If you have submitted your proxy by the
Internet or telephone there is no need to mail your proxy card.
For Shareholders who have elected to receive UniSource Energy's Proxy Statement
and Annual Report electronically you can now view the 2005 Annual Meeting
materials on the Internet by pointing your browser to
http://www.UnisourceEnergy.com.
1-866-358-4695
CALL TOLL-FREE TO VOTE
-------------------------------
THE INTERNET AND TELEPHONE VOTING FACILITIES WILL BE AVAILABLE UNTIL 5:00 P.M.
E.S.T. ON THURSDAY, MAY 5, 2005.
DETACH PROXY CARD HERE IF YOU ARE NOT VOTING BY THE INTERNET OR TELEPHONE.
-------------------------------------------------------------------------------
(FORM OF PROXY CARD - FRONT)
Please Sign, Date and Return [X]
the Proxy Promptly Using the Votes MUST be indicated (x)
Enclosed Envelope. in Black or Blue Ink.
The Board of Directors Recommends a vote "FOR" the following proposal:
1. Election of Directors
FOR all nominees WITHHOLD AUTHORITY to vote *EXCEPTIONS [ ]
listed below for all nominees listed
[ ] below [ ]
Nominees: 01-James S. Pignatelli, 02-Lawrence J. Aldrich, 03-Larry W. Bickle,
04-Elizabeth T.Bilby, 05-Harold W. Burlingame, 06-John L. Carter,
07-Robert A. Elliott, 08-Kenneth Handy, 09-Warren Y. Jobe
(INSTRUCTIONS: To withhold authority to vote for any individual nominee, mark
the "Exceptions" box and write that nominee's name in the space provided
below).
*Exceptions
------------------------------------------------------------------
If you agree to access our
Annual Report and Proxy
Statement electronically in
the future, please mark this
box. [ ]
To change your address,
please mark this box. [ ]
To include any comments,
please mark this box. [ ]
-----------------------------------
SCAN LINE
-----------------------------------
PLEASE SIGN EXACTLY AS YOUR NAME APPEARS
HEREON. When shares are held by joint
tenants in common or as community
property, both should sign. When
signing as attorney, executor,
administrator, trustee, guardian or
custodian, please give full title as
such. If a corporation, please sign in
corporate name by President or other
authorized officer. If a partnership,
please sign in partnership name by
authorized person. Receipt is hereby
acknowledged of Notice of Annual
Meeting, Proxy Statement and the 2004
Annual Report.
Date Shareholder sign here
----------------------------------------
Date Co-Owner sign here
----------------------------------------
-------------------------------------------------------------------------------
B-1
[A street map showing the location Marriott University Park Hotel
of the Annual Shareholders' Meeting 880 East Second Street
is set forth in this area.] Tucson, AZ 85719
520.792.4100 Hotel Direct
800.228.9290 Reservations
TRANSPORTATION
From Tucson International Airport
Shuttle Service
Arizona Stagecoach
Call 520-889-1000
Automobile - Interstate 10 to
Speedway exit
DEAR SHAREHOLDERS:
If you previously elected to view the UniSource Energy Corporation Proxy
Statements and Annual Reports over the Internet instead of receiving copies in
the mail, you can now access the Proxy Statement for the 2005 Annual
Shareholders' Meeting and the 2004 Annual Report on the Internet through the
following address: http://www.UniSourceEnergy.com. You can vote your shares by
telephone, the Internet, Mail or in Person at the Annual Shareholders' Meeting.
See the Proxy Statement and the enclosed proxy card for further information
about voting procedures.
If you would like a paper copy of the Proxy Statement and Annual Report,
UniSource Energy will provide a copy to you upon request. To obtain a copy of
these documents, please call 866-275-4867.
-------------------------------------------------------------------------------
(FORM OF PROXY CARD - BACK)
UNISOURCE ENERGY
This Proxy is Solicited on Behalf of the Board of Directors of the Company
for the Annual Shareholders' Meeting to be held Friday, May 6, 2005.
P R O X Y
The undersigned hereby appoints James S. Pignatelli and Kevin P. Larson,
and each of them, with the power of substitution, to represent and to vote on
behalf of the undersigned all shares of Common Stock which the undersigned is
entitled to vote at the Annual Shareholders' Meeting scheduled to be held at
the Marriott University Park Hotel, 880 East Second Street, Tucson, Arizona,
on Friday, May 6, 2005, and at any adjournments or postponements thereof,
with all powers the undersigned would possess if personally present and in
their discretion, upon such other business as may properly come before the
meeting. This proxy, when properly executed, will be voted in the manner
directed herein by the undersigned shareholder. IF NO DIRECTION IS MADE,
THIS PROXY WILL BE VOTED "FOR" Proposal 1.
B-2
SCHEDULE 14A
(Rule 14a-101)
INFORMATION REQUIRED IN PROXY STATEMENT
SCHEDULE 14A INFORMATION
Proxy Statement Pursuant to Section 14(a) of the Securities
Exchange Act of 1934 (Amendment No. 1)
Filed by the Registrant [X]
Filed by a Party other than the Registrant [_]
Check the appropriate box:
[_] Preliminary Proxy Statement
[_] Confidential. For Use of the Commission Only (as permitted by Rule
14a-6(e)(2))
[X] Definitive Proxy Statement
[_] Definitive Additional Materials
[_] Soliciting Material Pursuant to Section 240.14a-12
UNISOURCE ENERGY CORPORATION
-------------------------------------------------
(Name of Registrant as Specified In Its Charter)
-------------------------------------------------
(Name of Person(s) Filing Proxy Statement, if other than the Registrant)
Payment of Filing Fee (Check the appropriate box):
[X] No fee required.
[_] Fee computed on table below per Exchange Act Rules 14a-6(i)(4) and 0-11.
(1) Title of each class of securities to which transaction applies:
-------------------------------------------------
(2) Aggregate number of securities to which transaction applies:
-------------------------------------------------
(3) Per unit price or other underlying value of transaction computed pursuant to
Exchange Act Rule 0-11 (set forth the amount on which the filing fee is
calculated and state how it was determined):
-------------------------------------------------
(4) Proposed maximum aggregate value of transaction:
-------------------------------------------------------------------------------
(5) Total fee paid:
-------------------------------------------------------------------------------
[_] Fee paid previously with preliminary materials.
[_] Check box if any part of the fee is offset as provided by Exchange Act Rule
0-11(a)(2) and identify the filing for which the offsetting fee was paid
previously. Identify the previous filing by registration statement number, or
the Form or Schedule and the date of its filing.
(1) Amount Previously Paid:
-------------------------------------------------------------------------------
(2) Form, Schedule or Registration Statement No.:
-------------------------------------------------------------------------------
(3) Filing Party:
-------------------------------------------------------------------------------
(4) Date Filed:
AMENDMENT TO PROXY STATEMENT FOR THE
ANNUAL SHAREHOLDERS' MEETING
TO BE HELD ON MAY 6, 2005
To the Holders of Common Stock of
UniSource Energy Corporation
UniSource Energy Corporation's (the Company's) proxy statement, first
distributed to shareholders beginning April 6, 2005, relating to the Company's
2005 annual meeting to be held on May 6, 2005, inadvertently omitted Barclays
Global Investors, NA. from the table on page [5] entitled "Security Ownership of
Certain Beneficial Owners." The following information for Barclays Global
Investors, NA. should have been included in that table:
Amount and
Title of Name and Address Nature of
Class of Beneficial Owner Beneficial Ownership Percent of Class
-------- ------------------- -------------------- ----------------
Common Barclays Global Investors, NA. 2,377,283 (3) 6.9%
45 Fremont Street
San Francisco, CA 94105
(3) In a statement (Schedule 13G) filed with the SEC on February 14, 2005,
Barclays Global Investors, NA., indicated that it has sole voting power
over 2,193,239 shares of the Company's common stock, and shared dispositive
power over 2,377,283 shares of the Company's common stock. The filing
indicated that the 2,377,283 shares are owned by Barclays Global Investors,
NA. (1,187,833 shares), Barclays Global Fund Advisors (927,067 shares),
Barclays Capital Securities Limited (23,783) and Palomino Limited (238,600
shares).
PART II. INFORMATION NOT REQUIRED IN PROSPECTUS
ITEM 13. OTHER EXPENSES OF ISSUANCE AND DISTRIBUTION.
The expenses, other than underwriting discounts and commissions, in
connection with the issuance and distribution of the securities being registered
are:
Securities and Exchange Commission registration fee........... $ 17,655
Legal fees and expenses....................................... 75,000
Accountants' fees............................................. 10,000
Printing, including registration statement,
prospectuses, exhibits, etc............................... 30,000
Trustees fees and expenses.................................... 20,000
Miscellaneous................................................. 10,000
--------
Total......................................................... $162,655
========
All of the above except the Securities and Exchange Commission registration fee
are estimated.
ITEM 14. INDEMNIFICATION OF DIRECTORS AND OFFICERS.
Article SIXTH of the Restated Articles of Incorporation of UniSource
Energy, as amended, provides in pertinent part as follows:
SIXTH:
(B) No director of the Corporation shall be personally liable to the
Corporation or its shareholders for money damages for any action taken or any
failure to take any action as a Director; provided, however, that nothing herein
shall be deemed to eliminate or limit any liability which may not be so
eliminated or limited under the laws of the State of Arizona, as in effect at
the effective date of this paragraph (B) of Article SIXTH or as thereafter
amended. No amendment, modification or repeal of this paragraph (B) shall
eliminate or limit the protection afforded by this paragraph (B) to a director
with respect to any act or omission occurring before the effective date thereof.
(C) (1) The Corporation shall, to the maximum extent permitted by
applicable law, as from time to time in effect, indemnify any individual who is
or was a party to or otherwise involved in (or threatened to be made a party to
or otherwise involved in) any Proceeding (as hereinafter defined) because such
individual is or was a director or officer of the Corporation, or, while a
director or officer of the Corporation, is or was serving at the request of the
Corporation as a director, officer, partner, trustee, employee or agent of
another foreign or domestic corporation, partnership, joint venture, trust,
employee benefit plan or other enterprise, against all Liability (as hereinafter
defined) incurred by such individual in connection with such Proceeding.
As used in this paragraph (C) of Article SIXTH, (a) the term "Expenses"
includes attorneys' fees and all other costs and expenses reasonably related to
a Proceeding; (b) the term "Liability" means the obligation to pay a judgment,
settlement, penalty or fine (including any excise tax assessed with respect to
an employee benefit plan) and reasonable Expenses incurred with respect to a
Proceeding, and includes without limitation obligations and Expenses that have
not yet been paid but that have been or may be incurred; and (c) the term
"Proceeding" means any threatened, pending or completed action, suit or
proceeding, whether civil, criminal, administrative or investigative and whether
formal or informal, including without limitation any action, suit or proceeding
by or in the right of the Corporation and including, further, any appeal in
connection with any such action, suit or proceeding.
(2) The Corporation shall, to the maximum extent permitted by
applicable law, pay any Expenses incurred by a director or officer of the
Corporation in defending any such Proceeding in advance of the final disposition
thereof upon receipt of any undertaking by or on behalf of such individual to
II-1
repay such advances if it is ultimately determined that such individual did not
meet any standard of conduct prescribed by applicable law and upon the
satisfaction of such other conditions as may be imposed by applicable law.
(3) The Corporation, by resolution of the Board of Directors, may
extend the benefits of this paragraph (C) of Article SIXTH to employees and
agents of the Corporation (each individual entitled to benefits under this
paragraph (C) being hereinafter sometimes called an "Indemnified Person").
(4) All rights to indemnification and to the advancement of expenses
granted under or pursuant to this paragraph (C) shall be deemed to arise out of
a contract between the Corporation and each person who is an Indemnified Person
at any time while this paragraph (C) is in effect and may be evidenced by a
separate contract between the Corporation and each Indemnified Person; and such
rights shall be effective in respect of all Proceedings commenced after the
effective date of this paragraph (C), whether arising from acts or omissions
occurring before or after such date. No amendment, modification or repeal of
this Article shall affect any rights or obligations theretofore existing.
(5) The Corporation may purchase and maintain insurance on behalf of,
or insure or cause to be insured, any individual who is an Indemnified Person
against any Liability asserted against or incurred by him in any capacity in
respect of which he is an Indemnified Person, or arising out of his status in
such capacity, whether or not the Corporation would have the power to indemnify
him against such liability under this Article. The Corporation's indemnity of
any individual who is an Indemnified Person shall be reduced by any amounts such
individual may collect with respect to such liability (a) under any policy of
insurance purchased and maintained on his behalf by the Corporation or (b) from
any other entity or enterprise served by such individual.
(6) The rights to indemnification and to the advancement of Expenses
and all other benefits provided by, or granted pursuant to, this Article shall
continue as to a person who has ceased to serve in the capacity in respect of
which such person was an Indemnified Person and shall inure to the benefit of
the heirs, executors and administrators of such person.
(7) The Board of Directors shall have the power and authority to make,
alter, amend and repeal such procedural rules and regulations relating to
indemnification and the advancement of Expenses as it, in its discretion, may
deem necessary or expedient in order to carry out the purposes of this Article,
such rules and regulations, if any, to be set forth in the Bylaws of the
Corporation or in a resolution of the Board of Directors.
ITEM 15. RECENT SALES OF UNREGISTERED SECURITIES
The discussion of UniSource Energy's sale of the securities covered by
this registration statement is contained in Appendix A to the prospectus
contained in the registration statement and is incorporated into this Item 15 by
reference.
ITEM 16. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES.
The list of exhibits under the heading INDEX TO EXHIBITS beginning on
page II-6 of this registration statement is incorporated into this Item 16 by
reference. The financial statement schedule contained in Appendix A to the
prospectus contained in this registration is incorporated into this Item 16 by
reference.
ITEM 17. UNDERTAKINGS.
a. The undersigned registrant hereby undertakes:
(1) To file, during any period in which offers or sales are being
made, a post-effective amendment to this registration statement:
(i) To include any prospectus required by Section 10(a)(3) of
the Securities Act of 1933;
II-2
(ii) To reflect in the prospectus any facts or events arising
after the effective date of the registration statement (or
the most recent post-effective amendment thereof) which,
individually or in the aggregate, represent a fundamental
change in the information set forth in the registration
statement. Notwithstanding the foregoing, any increase or
decrease in volume of securities offered (if the total
dollar value of securities offered would not exceed that
which was registered) and any deviation from the low or high
end of the estimated maximum offering range may be reflected
in the form of prospectus filed with the SEC pursuant to
Rule 424(b) if, in the aggregate, the changes in volume and
price represent no more than 20 percent change in the
maximum aggregate offering price set forth in the
"Calculation of Registration Fee" table in the effective
registration statement; and
(iii) To include any material information with respect to the
plan of distribution not previously disclosed in the
registration statement or any material change to such
information in the registration statement,
provided, however, that paragraphs (a)(1)(i) and (a)(1)(ii) do
not apply if the registration statement is on Form S-3, Form S-8
or Form F-3, and the information required to be included in a
post-effective amendment by those paragraphs is contained in
periodic reports filed with or furnished to the SEC by the
registrant pursuant to Section 13 or Section 15(d) of the
Securities Exchange Act of 1934 that are incorporated by
reference in the registration statement.
(2) That, for the purpose of determining any liability under the
Securities Act of 1933, each such post-effective amendment shall
be deemed to be a new registration statement relating to the
securities offered therein, and the offering of such securities
at that time shall be deemed to be the initial bona fide offering
thereof.
(3) To remove from registration by means of a post-effective
amendment any of the securities being registered which remain
unsold at the termination of the offering.
(4) That, for purposes of determining any liability under the
Securities Act of 1933, each filing of its Annual Report pursuant
to Section 13(a) or Section 15(d) of the Securities Exchange Act
of 1934 that is incorporated by reference in the registration
statement shall be deemed to be a new registration statement
relating to the securities offered herein, and the offering of
such securities at that time shall be deemed to be the initial
bona fide offering thereof.
b. Insofar as indemnification for liabilities arising under the
Securities Act of 1933 may be permitted to directors, officers and
controlling persons of the registrant pursuant to the provisions
described under Item 15 above, or otherwise, the registrant has been
advised that in the opinion of the SEC such indemnification is against
public policy as expressed in the Securities Act of 1933 and is,
therefore, unenforceable. In the event that a claim for
indemnification against such liabilities (other than the payment by
the registrant of expenses incurred or paid by a director, officer or
controlling person of the registrant in the successful defense of any
action, suit or proceeding) is asserted by such director, officer or
controlling person in connection with the securities being registered,
the registrant will, unless in the opinion of its counsel the matter
has been settled by controlling precedent, submit to a court of
appropriate jurisdiction the question whether such indemnification by
it is against public policy as expressed in the Securities Act of 1933
and will be governed by the final adjudication of such issue.
II-3
POWER OF ATTORNEY
Each director and/or officer of UniSource Energy Corporation whose
signature appears below hereby appoints Kevin P. Larson, Vincent Nitido, Jr.,
Esq., and Karen G. Kissinger, and each of them severally, as his/her
attorney-in-fact to sign in his/her name and behalf, in any and all capacities
stated below, and to file with the Securities and Exchange Commission any and
all amendments, including post-effective amendments, to this registration
statement; and the registrant hereby also appoints each such agent for service
as its attorney-in-fact with like authority to sign and file any such amendments
in its name and on its behalf.
SIGNATURES
Pursuant to the requirements of the Securities Act of 1933, the
registrant certifies that it has reasonable grounds to believe that it meets all
of the requirements for filing on Form S-1 and has duly caused this registration
statement to be signed on its behalf by the undersigned, thereunto duly
authorized, in the City of Tucson, State of Arizona, on June 27, 2005.
UNISOURCE ENERGY CORPORATION
By /s/ Kevin P. Larson
-------------------------------------
(Kevin P. Larson, Vice President,
Treasurer and Principal Financial
Officer)
Pursuant to the requirements of the Securities Act of 1933, this
registration statement has been signed by the following persons in the
capacities and on the dates indicated.
SIGNATURE TITLE DATE
--------- ----- ----
/s/ James S. Pignatelli Principal Executive June 27, 2005
--------------------------------------- Officer and Director
(James S. Pignatelli, Chairman of
the Board and Chief Executive)
/s/ Kevin P. Larson Principal Financial June 27, 2005
--------------------------------------- Officer
(Kevin P. Larson, Vice President,
Treasurer and Chief Financial Officer)
/s/ Karen G. Kissinger Principal Accounting June 27, 2005
-------------------------------------- Officer
(Karen G. Kissinger, Vice President,
Controller and Chief Compliance Officer)
/s/ Lawrence J. Aldrich Director June 27, 2005
--------------------------------------
(Lawrence J. Aldrich)
/s/ Larry W. Bickle Director June 27, 2005
--------------------------------------
(Larry W. Bickle)
/s/ Elizabeth T. Bilby Director June 27, 2005
--------------------------------------
(Elizabeth T. Bilby)
/s/ Harold W. Burlingame Director June 27, 2005
--------------------------------------
(Harold W. Burlingame)
II-4
/s/ John L. Carter Director June 27, 2005
-------------------------------------
(John L. Carter)
/s/ Robert A. Elliott Director June 27, 2005
--------------------------------------
(Robert A. Elliott)
/s/ Kenneth Handy Director June 27, 2005
--------------------------------------
(Kenneth Handy)
/s/ Warren Y. Jobe Director June 27, 2005
--------------------------------------
(Warren Y. Jobe)
II-5
INDEX TO EXHIBITS
PREVIOUSLY FILED*
-----------------
WITH FILE AS
EXHIBITS NUMBER EXHIBIT
-------- ------ -------
3(a) 1-13739 2(a) -- Amended and Restated Articles of Incorporation.
Form 8-A/A, dated
January 30, 1998
3(b) 1-13739 2(b) -- Bylaws, as amended May 20, 1994.
Form 8-A/A, dated
January 30, 1998
4(a) 1-13739 4.1 -- Indenture, dated as of March 1, 2005, between UniSource
Form 8-K, dated Energy Corporation and The Bank of New York, as trustee.
March 3, 2005
4(b) 1-13739 4.2 -- Registration Rights Agreement, dated March 1, 2005, among
Form 8-K, dated UniSource Energy Corporation and Credit Suisse First Boston
March 3, 2005 LLC, as representatives of the several initial purchasers
named therein.
4(c) 1-13739 4 Rights Agreement, dated as of March 5, 1999, between
Form 8-K, dated UniSource Energy Corporation and The Bank of New York, as
March 5, 1999 Rights Agent
5(a) -- Opinion of Thelen Reid & Priest LLP, special counsel for
UniSource Energy Corporation
5(b) -- Opinion of Vincent Nitido, Jr., Esq., Vice President and
General Counsel for UniSource Energy Corporation
8 -- Opinion of Thelen Reid & Priest LLP with respect to material
United States federal tax matters contained in Exhibit 5(a)
10+ -- Material Contracts
12 1-13739 12(a) -- Statement of Computation of Ratio of Earnings to Fixed Charges
Form 10-Q for
quarter ended March
31, 2005
15 -- Awareness Letter of PricewaterhouseCoopers LLP regarding the
use of unaudited interim financial information
21 1-13739 21 -- Subsidiaries of UniSource Energy Corporation
Form 10-K for fiscal
year ended December
31, 2004
23(a) -- Consent of PricewaterhouseCoopers LLP, Independent Registered
Public Accounting Firm for UniSource Energy Corporation
23(b) -- Consent of PricewaterhouseCoopera LLP, Independemt Registered
Public Accounting Firm for Tuscon Electric Power Company
II-6
PREVIOUSLY FILED*
-----------------
WITH FILE AS
EXHIBITS NUMBER EXHIBIT
-------- ------ -------
23(c) -- Consent of Thelen Reid & Priest LLP is contained in exhibit
5(a)
23(d) -- Consent of Vincent Nitido, Jr., Esq., is contained in exhibit
5(b)
24 -- Power of Attorney (see page II-4 herein)
25 -- Statement of Eligibility of trustee on Form T-1
-------------------
*Incorporated herein by reference
+To be filed by pre-effective amendment
II-7